Don’t Believe the Hype; No Tax Holiday For Foreign Partners In U.S. Partnerships
Articles with controversial headers have flooded the usually stoic accounting community upon a recent Tax Court decision.
- "Non-US Partner's Gain on Disposition of US Partnership Interest Not Taxable in US",
- "Tax Court Declines to Follow Revenue Ruling that Sale of Partnership Interest Creates Effectively Connected Income"
The list goes on.
The hype arose when a Tax Court recognized that the petitioner, Grecian Magnesite Mining (“GMM”), may exclude a $4 million capital gain from its US taxable income. The gain resulted from the disposition (sale) of GMM’s interest in the U.S. Partnership Premier Chemicals (Premier).
Precedent-setting rule --- premature and excessive
While we have seen other commentators label this "A precedent-setting ruling that changes the way foreigners are taxed in the US" - we believe this is premature and excessive. These are a few muted factors that need to be taken into account.
The total capital gain from the disposition of interest by GMM in the U.S. Partnership was $6.2M, of which $2.2M were treated as U.S.-sourced capital gain attributable to the sale of U.S. real estate. This part was mutually agreed by the Petitioner and the Commissioner.
The remaining $4M was the matter of discussion. The tax court sustained this portion from disposition of partnership interest as a foreign-sourced gain.
However, the treatment of gains from the disposition of partnership interest as foreign-sourced is not universal and aforementioned Tax Court opinion does not override prior IRS ruling on disposition of partnership interest.
Apples And Oranges
Under section 864(c)(5)(B), income, gain, or loss is attributable to a U.S. office if:
- (a) the U.S. office is “a material factor in the production of such income”,
- (b) the U.S. office “regularly carries on activities of the type from which such income, gain, or loss is derived.”
The petitioner succeeded in proving to the Commissioner that given the nature of the foreign partner’s business activities and the specifics of the operating agreement between GMM and Premier, the gain from the disposition of partnership interest is not attributable to the U.S. office
- GMM is a foreign company in the business of extracting, producing, and commercializing magnesia and magnesite, which it sells to customers around the world. GMM owns magnesite deposits in Greece, has a research and development facility in Greece, and has an office in Greece. Other than through its ownership interest in Premier, GMM had no office, employees, or business operation in the United States.
- Premier, the U.S. LLC, is in the business of extracting, producing, and distributing magnesite which it mines or extracts in the United States. It owned mines and industrial properties in various States, including Nevada, Florida, and Pennsylvania.
The Increase in value of GMM partnership interest resulted from GMM business activity carried out outside the United States. The Commissioner acknowledges that “the income at issue does not fall within the limited categories of section 864(c)(4)(B).”
One Tall Order
Using the said Tax court decision as a precedent is a daunting task. The tax practitioner would carry a burden of proof for two tests:
- Whether the U.S. partnership office was a material factor in the production of the foreign partner disputed gain
- Whether the disputed gain was realized in the ordinary course of the U.S. Partnership business.
In order to meet the tests the foreign partner has to be an independent entity carrying out income-producing activities outside of the United States.
A typical foreign limited partner is not engaged in business activities giving rise to his interest in US partnership. Growth of the partner’s capital account results from the distributive share of U.S. partnership income.
The gain from disposition of this partnership interest (capital asset) would still be treated as effectively connected with a U.S. trade or business, consistent with Rev. Rul. 91-32 - thus, taxable in the U.S.