A version of this article, titled "Foreign Partners Fall Victim to Tax Reform," was published on March 27, 2018 on the Middle Market Growth website, produced by the Association of Corporate Growth (ACG).
More than 25 years after the IRS announced its position that foreign partners were subject to tax on the gain from the sale of the partnership interests, the Tax Court decided in favor of taxpayers. Less than six months later, Congress overturned the decision by statute in connection with the Tax Cuts and Jobs Act (the Act), which was signed into law by President Trump on December 22, 2017. This article describes the issues that foreign limited partners (LPs) are facing in light of the change in law.
Taxation of Foreign Investors in Partnerships Generally
Foreign investors generally are subject to tax in the United States only on their U.S.-source fixed or determinable annual or periodical income (FDAP), such as U.S.-source interest and dividends (but not including capital gains). The tax is imposed (by way of withholding) at a flat 30 percent (or lower treaty rate).
Partners (rather than the partnerships in which they invest) are subject to tax on their distributive share of partnership income. Additionally, the character of income recognized by a partnership (such as interest, dividends or capital gains) retains this character when allocated to the partners. Similarly, if a partnership is engaged in a trade or business, all of its foreign partners are treated as being engaged in the same trade or business. Thus, income recognized by a partnership that is effectively connected to a trade or business in the United States (ECI) flows through to foreign partners, and these foreign partners generally are subject to tax in the United States in the same manner as U.S. persons (at regular corporate or individual rates, as applicable, on net income). They also must file U.S. federal income tax returns. Foreign corporate partners may be subject to the 30 percent (or lower treaty rate) branch profits tax (BPT) in addition to regular income tax.
IRS Rulings on Sales of Partnership Interests
In 1991, the IRS issued Revenue Ruling 91-32,1 in which it concluded that the gain or loss of a foreign LP resulting from the sale of an interest in a partnership that conducts a trade or business through a fixed place of business in the United States constitutes U.S.-source ECI to the extent that the partner’s distributive share of unrealized gain or loss is attributable to property used by the partnership in a trade or business. As a result, a foreign LP would be subject to tax in the United States on the capital gain it recognizes from the sale of an interest in a partnership if the partnership is engaged in a U.S. trade or business. According to the IRS, tax treaties provided no additional protection to foreign LPs because any gain recognized on the sale of the partnership interest would be considered attributable to the partnership’s office or fixed place of business (i.e., a permanent establishment for treaty purposes) and, thus, treaties would permit the taxation of this gain as business profits.2
The Grecian Magnesite Case
The issue was recently the subject of litigation in the Tax Court.3 Grecian Magnesite Mining, Industrial & Shipping Co. is a Greek mining and industrial concern that specializes in magnesite. In 2001, Grecian became a founding member of Premier Magnesia, LLC (f/k/a Premier Chemicals LLC), which is treated as a partnership for U.S. tax purposes. Premier extracts magnesite from a mine in Nevada, manages its business through headquarters in Pennsylvania, and conducts all of its operations through offices and facilities within the United States.
On July 21, 2008, Grecian entered into an agreement with Premier to redeem its membership interest. The redemption was accomplished in two phases, each of which generated a gain. Grecian did not report any gain on its 2008 U.S. income tax return from the redemption of its interest in Premier and did not file a tax return in 2009.
On July 13, 2017, the Tax Court4 ruled that the gain was a capital gain that was not U.S.-source income and that was not effectively connected with a U.S. trade or business, thereby declining to follow Revenue Ruling 91-32. In its detailed opinion, the Tax Court was critical of Revenue Ruling 91-32, pointing to four fatal flaws in the government’s position.
IRS Position Codified
Although President Obama tried several times to codify the IRS’s position in Revenue Ruling 91-32, the change was not made. Neither the tax proposals of republican lawmakers nor President Trump’s campaign promises related to tax reform gave any indication that this was a hot issue for them. Nevertheless, when the Senate unveiled its amendments to the Act, it included a provision codifying the IRS position, and overturning (on a prospective basis) Grecian Magnesite, which became part of the final Act.
Under the Act, gain or loss on the sale or exchange of a partnership interest constitutes ECI to the extent that the transferor would have had ECI had the partnership sold all of its assets at fair market value on the date of the sale or exchange. In order to preclude foreign partners from attempting to avoid the new tax by selling in 2017, the law is effective for transfers on or after November 27, 2017.
New Withholding Tax Creates New Issues
The transferee of a partnership interest is required to withhold 10 percent of the amount realized on the sale or exchange of a partnership interest unless the transferor certifies that the transferor is not a foreign person or that none of the gain would constitute ECI. As drafted, if even $1 of the gain would constitute ECI, the transferee must withhold 10 percent of the gross proceeds from the sale. Similarly, if the gross proceeds exceed the gain on the transfer, the transferee must withhold 10 percent of the gross proceeds. If the transferee fails to withhold, then the partnership itself must do so.
This is an extreme departure from the analogous rules related to withholding on the transfer of a partnership interest where the partnership owns U.S. real estate. In that case, withholding is not even required unless at least 50 percent of the gross assets of the partnership are composed of U.S. real property interests.5 Although it is unlikely that the IRS will use its regulatory authority to limit withholding to situations where ECI assets of the partnership are so high, the IRS could provide procedures to limit withholding based on the actual amount of gain that would constitute ECI, as it has done in the Foreign Investment in Real Property Tax Act of 1980 area.
Is There Life Left in Grecian Magnesite?
The government has appealed the decision in Grecian Magnesite. The Tax Court was critical of the position in Revenue Ruling 91-32 and in the case itself. The government’s inability to cite relevant authorities or make compelling arguments strongly supports certain tax practitioners’ longstanding view that, except to the extent attributable to U.S. real property interests, foreign LPs were not taxable on gain from the sale of partnership interests before November 27, 2017. Accordingly, foreign investors that did pay tax on gain from the sale of partnership interests should consider whether the statute of limitations is still open to claim a refund for such taxes.
The Act settles a 25-year debate over the taxation of foreign partners on the sale of partnership interests in the IRS’s favor. In doing so, it likely increases the U.S. tax burden on foreign partners that sell partnership or LLC interests (or have such interests redeemed). Blockers and alternative investment vehicles can move the tax and reporting obligations to corporate vehicles, away from the foreign partners, but this will not mitigate the ultimate tax liability, as most practitioners believed before the Act. Moreover, withholding is required on gross proceeds from the gain if even the slightest amount of gain would be ECI. The IRS has authority to reduce this burden to, for example, reduce withholding based on the actual amount of gain, though it is questionable whether the IRS will adopt a significant threshold of ECI gain before withholding is required. The IRS also will undoubtedly adopt procedures for the remission of withheld tax to the IRS, as the current procedures, which would apply to withholding by partnerships on ECI allocable to foreign partners, do not apply to withholding by transferees of partnership interests, other than those holding U.S. real property.
1 Revenue Ruling 91-32, 1991-1 C.B. 107.
2 In September 2012, the IRS Office of Chief Counsel released a memorandum reaffirming its position that a foreign partner was subject to tax on gain recognized by the foreign partner on the disposition of its interest in a partnership that was engaged in a trade or business in the United States. Field Attorney Advice (FAA) 20123903F.
3 Grecian conceded that gain attributable to U.S. real property interests held by Premier was taxable.
4 Grecian Magnesite Mining, Industrial & Shipping Co. S.A. v. Commissioner, 149 T.C. No. 3 (July 13, 2017).
5 There is a double threshold. Not only must the 50 percent threshold be satisfied, but 90 percent of the gross assets must consist of cash, cash equivalents and U.S. real property interests before withholding is required. Temporary Regulation 1.1445-11T.
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