The 2017 tax legislation (TCJA) added a section to the Internal Revenue Code—section 864(c)(8)—under which nonresident alien individuals and foreign corporations can be taxed on all or a portion of the gain from the sale of certain partnership interests. This article explains some of the events which led to the enactment of the legislation and discusses the far-reaching effect of this new provision.
The U.S. tax treatment of gain or loss on the sale of a partnership interest by a nonresident alien individual or a foreign corporation has been a perplexing issue. In 1991, the IRS issued Revenue Ruling 91-32 setting forth its position on this issue. The Service began its analysis by pointing out that a nonresident alien individual or foreign corporation that is a partner in a partnership that is engaged in a trade or business in the United States is itself considered to be engaged in a trade or business in the United States. With limited exceptions, income from the sale of personal property by such a partner is sourced to the United States if that partner has a fixed place of business in the United States and if the sale can be attributed to that fixed place of business.
It was already established that a foreign partner is considered to be engaged in a trade or business in the United States if a partnership in which that foreigner is a partner is engaged in a trade or business in the United States. Similarly, if that partnership has a fixed place of business in the United States, any foreign partner in that partnership is also considered to have a fixed place of business in the United States. Finally, income from the disposition of that partnership interest will be attributable to the foreign partner’s (or the partnership’s) fixed place of business in the United States.
The Service pointed out that gain or loss from the sale of a capital asset can be considered effectively connected with the conduct of a trade or business in the United States (ECI gain or loss) and thereby subject to U.S. taxation. One factor to be considered in determining whether gain or loss is ECI is whether the asset sold was used or held for use in the conduct of a trade or business in the United States. Another factor is whether the activities of that trade or business in the United States were a material factor in the realization of that gain or loss.
Indicating that the foreign partner’s gain or loss from the sale of its partnership interest was not realized directly from the conduct of a trade or business within the United States, the Service applied the regulation’s asset use test. The asset use test applies to sales of assets, among other activities. Under this test, gain from the sale of assets is sourced to the United States if the asset sold generates income that is taxed in the United States.
In summary, the Service concluded that a foreign partner in a partnership that has a fixed place of business in the United States is considered to be engaged in a U.S. trade or business that has a fixed place of business in the United States. Accordingly, the value of that trade or business affects the value of the partnership interest and the foreign partner has assets that generate income that is effectively connected with the United States.
The Revenue Ruling also recognized that not all partnership assets may be used in a partnership’s U.S. trade or business. Partnership taxation is sometimes based on an aggregate theory of taxation (that a partnership is an aggregation of interests owned by each of the partners) and is sometimes based on an entity theory of taxation (that a partnership is an entity separate and apart from its partners just as a corporation is an entity separate from its shareholders). The theory of taxation that is applied to a transaction or group of transactions depends on the purpose of the provisions governing the taxation of those transactions. Section 864, which governs the U.S. tax rules for foreign partners (among others) uses an aggregate approach that looks at the activities of each foreign partner. Accordingly, subjecting all of the gain on the sale of a partnership interest to U.S. taxation would be inconsistent with the provision, since it only taxes income that is effectively connected with a U.S. trade or business. Further, taxing all the income could be inconsistent with other provisions, such as section 897(g), which subjects to U.S. taxation gain on the sale of a U.S. real property interest but not gains on the sale of foreign real property interests. Subjecting all of the gain on a foreign partner’s sale of a partnership interest to U.S. taxation, regardless of the source of income generated by the partnership, would be inconsistent with those principles.
Accordingly, the Service concluded that it is appropriate to subject only certain gain on the sale of a partnership interest by a foreign partner to U.S. taxation if the assets of that partnership generate income that is effectively connected with the United States. That gain is based on the gain attributable to the sale of assets that generate ECI. Thus, the gain on the sale of a partnership interest that is subject to U.S. taxation is the total gain multiplied by a ratio of the gain from the sale of assets that generated ECI divided by the total gain on the sale of all of the assets of the partnership. In addition, there are certain limitations that apply in cases of an overall gain when there is a loss on the sale of assets that generate ECI, and in cases of an overall loss when there is a gain on the sale of assets that generate ECI.
This guidance remained valid until 2017, when the Tax Court rejected its validity in Grecian. Grecian Magnesite Mining (GMM) was a Greek corporation with no connection with the United States until 2001 when it purchased an interest in Premier, a Delaware limited liability company that was treated as a partnership for U.S. tax purposes. Premier owned several mines and industrial properties in the United States and its activities caused GMM to be treated as engaged in a U.S. trade or business under section 875(1). In 2008, Premier redeemed another member’s interest and, under the agreement, had to offer to redeem any other member’s interest on similar terms. GMM accepted the offer and its interest was redeemed. The proceeds of $10.6 million were paid in two installments: $5.3 million in July 2008 and the same amount in January 2009. The parties agreed that the effective date of the final transfer of GMM’s interest in Premier was December 31, 2008. From that date, GMM was not considered a member of Premier nor entitled to any profit allocation.
GMM filed U.S. returns, reporting its share of Premier’s income. On its 2008 return, GMM reported its share of income from the Schedule K-1 it received but did not report any gain on the sale of its membership interest in Premier. GMM did not file a tax return for 2009.
The Service audited GMM’s returns for 2008 and 2009. The parties agreed that $2.2 million of GMM’s $6.2 million gain was ECI attributable to the sale of GMM’s interest in Premier’s U.S. real estate. The Service, however, concluded that GMM should have reported the full $6.2 million gain on the redemption of its interest in Premier as ECI.
The court concluded that the correct approach to this problem was to first determine how this sale would be treated under the rules applicable to partnership taxation. Once that had been determined, the court could then look at the treatment of that type of transaction under the principles governing U.S. taxation of international transactions. It noted the partnership rules characterizing a liquidating distribution under section 736(b)(1) as a distribution under section 731, under which any gain or loss is characterized as a sale or exchange of the partnership interest under section 741. That section treats gain or loss as arising from sale of a capital asset unless section 751 (relating to unrealized receivables and inventory items) applies.
The Commissioner countered that section 741 applies an entity theory whereas this situation in the international context demands an aggregate theory whereby gain or loss is considered as arising from the sale of individual assets. The court rejected this argument, pointing out that section 741 refers to “capital asset” and section 731 refers to the “sale or exchange of a partnership interest.” In both cases, the singular is used, suggesting that Congress intended to apply an entity theory as the general rule for sales of interests in a partnership. The court found the Revenue Ruling lacking in the kind of discussion necessary to make its counterargument persuasive.
The court then considered whether the gain should be treated as U.S.-source income and thus ECI. Having found the Revenue Ruling’s analysis unpersuasive on the domestic taxation issues, the court also found its discussion of international taxation inadequate. Under the default rule on the source of a non-resident’s gain from a sale of personal property (including, e.g., a partnership interest), gain will not be U.S.-source unless an exception applies. Since GMM was a nonresident, the court considered that the gain was sourced outside of the United States.
The Commissioner contended that the U.S. office rule applied here as an exception to the general rule, resulting in gain from the sale of personal property that is attributable to such an office being sourced to the United States. Since the activities of Premier’s U.S. office (which was also thereby GMM’s U.S. office) increased the value of GMM’s interest in Premier, the gain GMM realized was attributable to the activities of GMM’s U.S. office and therefore sourced to the United States. This argument was rejected on the grounds that the U.S. office rule requires that the office be a material factor in the sale that generated the income in question. The Commissioner did not contend that the U.S. office was involved in the redemption but only that it created added value in the partnership interest over time. Even if Premier’s U.S. office had been a material factor, that gain would have had to have been realized in the ordinary course of business in that office to be attributable to it. Producing and selling magnesite products, not redemptions, were Premier’s ordinary course of business. Therefore, the gain was not taxable by the United States.
Shortly after the Grecian case was decided, Congress enacted section 864(c)(8) as part of the 2017 tax legislation to provide for the U.S. taxation of gain on the disposition of a partnership interest by a non-resident individual or a foreign corporation. The amount of gain subject to tax is based on the gain allocable to the selling partner that the partnership would have realized on the sale of its assets that produce ECI. Similarly, the loss that would be recognized is based on the loss allocable to the selling partner that the partnership would have realized on the sale of its assets that produce ECI. The legislation, in other words, overturns the Grecian holding and sets out a schema that comports with that outlined in the 1991 revenue ruling. Congress also enacted a 10% withholding provision that applies to the interest buyer or the partnership in certain circumstances. In December 2018, extensive proposed regulations were issued under both sections 864(c)(8) and 1446. They provide guidance regarding computation of ECI gain or loss on a partnership interest transfer, coordination with the FIRPTA rules of section 897(g), application to tiered partnerships, and availability of treaty relief. They also include an “anti-stuffing” rule to prevent inappropriate reductions in the amounts of ECI in connection with the interest transfer.
What is interesting, and probably not apparent on first glance, is that section 864(c)(8) covers many transactions that may catch the unwary. For example, the provisions will apply to the disposition of any partnership interest if two requirements are met: (i) the seller is a non-resident individual or a foreign corporation (from the U.S. perspective) and (ii) the partnership interest that was sold has income effectively connected with the United States. For example, consider a Serbian individual who is engaged in wine making and invests in a French partnership that makes wine. The French partnership in turn is involved in a joint venture in the United States with U.S. wine distributors who will distribute the French wine in the United States. The French partnership would have ECI with the United States from its joint venture and would pass that income on to its partners, including the Serbian individual. If and when the Serbian partner sells his interest, he could have U.S. tax reporting obligations and be liable for U.S. tax. The joint venture between the French partnership and the U.S. wine distributors could also have a reporting obligation to its French partner. That obligation would be to report the gain or loss the joint venture would have realized on the sale of its assets. This is to enable the Serbian in the example to properly compute his U.S. tax obligation.
A further complication is that section 864(c)(8) covers any disposition in which a partner would recognize a gain on a transaction involving a partnership interest. This could include the gain from a decrease in a partner’s share of the partnership’s recourse or qualified nonrecourse liabilities. Let’s return to the Serbian partner. If he had a tax capital account of (500) and a share of partnership recourse liabilities of 1,000, he would have a U.S. tax basis of 500. Suppose he decided, for whatever reason, to place the partnership interest into a corporation. Suppose further that he could not, or chose not to, make a check-the-box election to treat the corporation as a disregarded entity. He would then have a gain of 500 from the relief of liabilities, resulting in some U.S.-source income, depending on the make-up of assets of the French partnership of which he was a partner and through which he has U.S.-source income.
Readers can certainly develop their own scenarios. Nonresident individuals and owners/officers of foreign corporations will have to be extremely careful if they own U.S. partnership interests. They, or their advisors, must know U.S. partnership tax law so that a determination can be made if they have gain taxable in the United States in any given year.
