Hands-off Management: Foreign investors score victory in US Tax Court ruling
On 13 July, the US Tax Court dealt a blow to the Internal Revenue Service (IRS), and relief to foreign investors, with its ruling in Grecian Magnesite Mining, Industrial & Shipping Co., SA, v. Commissioner of Internal Revenue.
When Grecian Magnesite Mining (GMM), a foreign corporation, sold its interest in Premier Chemicals, a US LLC, in 2008, it relied on its status as a non-US tax resident to assert that the proceeds received from that sale were not effectively connected with a US trade or business, and therefore not subject to US taxation.
The IRS contested this position by arguing:
Firstly, that the sale of a partnership interest is, in effect, the same as selling that partner’s proportionate share in each of the partnership’s business assets; therefore any proceeds would, in fact, be considered to be effectively connected to the active conduct of a US trade or business to the extent that, if the partnership sold those assets, the income received would be considered as such. This “aggregate approach” is the basis of the position laid out in the controversial Revenue Ruling 91-32, the facts of which largely mirror those of this case.
Secondly, that the general rule of income sourcing under IRC § 865(a) did not apply, relying on the “US office rule” exception of IRC § 865(e)(2)(A), which provides that income received by a non-US tax resident which is attributable to an office or other fixed place of business in the US, shall be sourced as US income.
In a decision years in the making, the US Tax Court rejected the first argument as laid out in Rev. Rul. 91-32, citing a lack of basis in the relevant statutes. The Court referred to the language in IRC § § 731 and 736, among others, which make specific reference to realizations of “the partnership interest” in concluding that, in contrast to the IRS’s aggregate approach, the “entity theory,” which suggests that an interest in a partnership is considered a distinct, indivisible asset in its own right, is, in fact, the standard rule for disposition of such an interest.
As to the second argument, the Court found that in order for IRC § 865(e)(2)(A) to apply, there needed to be a material connection from both the US presence of the foreign partner and the operational activities conducted in that location to the proceeds received. In this regard, the Court concluded that the IRS’s argument failed on both counts. Firstly, while the fact of the partner having a presence in the US did contribute to the increase in value of their interest in the partnership, it was not a direct material economic element in the realization of that income and did not contribute to the redemption transaction itself. Secondly, the business of Premier Chemicals was not to buy and sell partnership interests, and therefore this redemption of partnership interest could not be considered to have arisen in the ordinary conduct of business. As a result, the default sourcing of income to the jurisdiction of residence applies.
The Court noted, however, that to the extent that the proceeds from the sale were attributed to an interest in US real property, those proceeds are taxable pursuant to the FIRPTA rules of IRC § 897(g). As Premier Chemicals held US property, that proportion of the gain is taxable.
The fallout from this ruling has the potential to upend the scope of non-resident taxation for the foreseeable future. It is possible that the IRS will appeal the decision of the US Tax Court. If it does, it could be overturned on appeal. The IRS could also seek to publish regulations to reinstate its position or seek codification of Rev. Rul. 91-32 from Congress. However, the laundry list facing the current administration makes any immediate action unlikely. For the time being at least, Revenue Ruling 91-32 would appear to be invalidated.
This case serves as a reminder of how a current understanding of the changing tax landscape can prove vital for growing businesses. From a total gain of $6.2 million, only the $2.2 million attributable to US real property was taxable in this case, translating into millions in tax savings for GMM. Contact us if you have a tax query.