Five Things You Need to Know
On July 13, 2017, in Grecian Magnesite Mining, Industrial and Shipping Co. SA v. Commissioner (149 T.C. No. 3 (2017), the U.S. Tax Court concluded that gain recognized by a foreign corporation upon redemption of its interest in a partnership that was engaged in a U.S. trade or business (an ECI Partnership) was not subject to U.S. federal income tax. In reaching its decision, the Tax Court refused to follow the long-standing Internal Revenue Service (IRS) position articulated in Revenue Ruling 91-32 that an “aggregation” approach rather than “entity” approach applies to a non-U.S. partner’s disposition of an interest in an ECI Partnership. After determining an “entity” approach was more appropriate in this context, the court analyzed whether the gain at issue was effectively connected income (ECI). Certain categories of foreign source income can be ECI but the IRS acknowledged that the income at issue did not fall within any of those categories. Therefore, in order to be ECI, the income needed to be from U.S. sources. The court determined that the disposition of the partnership interest should be treated as a sale of personal property and that its source should be determined under section 865 of the Internal Revenue Code of 1986, as amended (the Code). Applying section 865 to the particular facts and circumstances before it, the court held that the gain at issue was not U.S. source income and therefore was not ECI.
It is important to note that the decision does not represent a blanket exemption from U.S. federal income tax for non-U.S. partners disposing interests in ECI Partnerships. First, the decision does not affect the general result (subject to exceptions such as the one that may be available for certain foreign pension funds) that gain from the sale of a partnership interest to the extent attributable to U.S. real estate is subject to U.S. federal income tax under the Foreign Investment in Real Property Tax Act of 1980 (FIRPTA). Second, non-U.S. partners that follow the analysis of the decision still will need to analyze whether their gain may be treated as ECI under their particular facts and circumstances.
Having said that, the Tax Court opinion is likely a welcome result for taxpayers but uncertainty remains as the IRS may move for reconsideration of the Tax Court opinion or appeal the decision to the Tenth Circuit Court of Appeals. A motion for reconsideration is not likely to be granted given that the case turned on a legal issue, while an appeal to the Tenth Circuit would likely be given serious consideration given the general deference that courts afford to IRS rulings. Until there is final resolution to the issue, uncertainty will continue for non-U.S. partners in ECI Partnerships and for such partnerships. Here is what those partners and partnerships need to know.