|Jim Fuller||David Forst|
The US Tax Court, in Grecian Magnesite Mining, Industrial & Shipping Co, SA v. Commissioner, 149 TC No. 3 (July 13 2017), held that a constructive sale by a foreign person of its interest in a partnership engaged in a US trade or business was not subject to US tax. In so doing, the court dismissed the conclusion of Revenue Rule 91-32 (Rev. Rul. 91-32) that a gain on the sale by a non-US partner of its interest in a partnership should be analysed asset-by-asset and treated as income effectively connected with the conduct of a trade or business (ECI) to the extent the partnership's underlying assets are used in a US trade or business. This ruling has been subject to heavy criticism since it was issued as not being in accordance with the Code and Regulations. The court's holding validates that criticism and positions taken by foreign taxpayers in accordance with the Code and Regulations rather than Rev. Rul. 91-32.
Based on the plain statutory language of section 741 of the Tax Code, the taxpayer argued that the constructive sale of partnership interest should be treated as the sale of an indivisible item (entity treatment) and may not be treated as the sale of the partnership's underlying assets (aggregate treatment), except for US real property held by the partnership that was subject to the separate FIRPTA rules. The Tax Court agreed, stating that, among other things, section 741 contains an exception to entity treatment (section 751). The reference in the text section 741 to section 751 is evidence that Congress is perfectly capable of making exceptions to entity treatment when it so desires, and that it has not expressed such a desire here.
Having affirmed that entity treatment applies, the court then addressed whether the taxpayer's gain (from selling, and being treated for tax purposes as selling) its partnership interest should be subject to US tax, i.e. be treated as income that is effectively connected with a US trade or business (ECI). The court declined to defer to Rev. Rul. 91-32 on this point, stating that the ruling "lacks the power to persuade", and that its treatment of the relevant subchapter K authority is "cursory in the extreme".
Rather, the court looked to the basic sourcing rule, section 865(a), which states that gain from the sale of personal property is sourced according to the residence of the seller. The court rejected the IRS's argument that an exception to section 865(a) applied – the "US office exception", in which a gain attributable to a US office is US source income and ECI. The court made a distinction between outside gain (gain of the partner from the sale of the partnership interest itself) and inside gain (gain of the partnership from selling its assets). The relevant item here was the outside gain, and according to the court, it is this income that must be tested under the US office rule. Accordingly, for the partnership's office to be a material factor in the realisation of the partner's outside gain, that office must be material to the transaction giving rise to this gain. According to the court, the office was not a factor in the "outside" transaction.