On December 20, 2018, the Department of Treasury and the Internal Revenue Service ("IRS") provided more details on Congress' swift reversal, under the Tax Cuts and Jobs Act of 2017 ("TCJA"), of the U.S. Tax Court's July 13, 2017 decision in the Grecian Mining case. The IRS confirmed that, contrary to the case decision, a foreign partner selling an interest in a partnership may be subject to U.S. federal income taxation ("USFIT"). In this Client Alert, we look at the turbulent history and take you through the mechanics of the newly codified rule, as well as highlight some traps for the unwary associated with the new rules.
Before the TCJA, the U.S. Internal Revenue Code (the “Code”) did not explicitly address the tax treatment of a foreign partner's gain or loss from the sale of a partnership that conducts a U.S. trade or business and/or holds U.S. assets (an “ECI Partnership”). In 1991, the IRS issued Revenue Ruling 91-32 (the “Ruling”), adopting what is generally known as the "aggregate theory" of partnership. The Ruling provided that gain derived by a foreign person from the sale or other disposition of an interest in an ECI Partnership should be treated as income effectively connected with a U.S. trade or business (such income known as "ECI") to the extent of the partnership's underlying U.S. business and/or assets. Accordingly, a foreign person’s sale or other disposition of an interest in an ECI Partnership has generally been treated as a sale of the partnership assets, with the gain treated as U.S. source income to the extent attributable to assets producing ECI.
In 2001, Grecian Magnesite Mining, Industrial & Shipping SA, a Greek corporation (“GMM”), acquired an interest in a Delaware limited liability company treated as a partnership for USFIT purposes (the “LLC”). The LLC, through its U.S. office and operations, was engaged in the mining and selling of minerals in the United States. In 2008, the LLC redeemed GMM’s partnership interest for cash. GMM treated its gain on this redemption as exempt from USFIT. Relying on the Ruling, the IRS challenged GMM's tax position on the redemption by arguing that the redemption gain was U.S. source income because it was ECI with respect to the LLC’s U.S. business and assets. GMM took the matter to the Tax Court where Judge David Gustafson sided with GMM, rejecting the Ruling. The Tax Court held that GMM's gain (with the exception of a portion that was attributable to a U.S. real property interest held by the LLC), was not subject to USFIT because it was not ECI, and thus was not U.S. source income. The Tax Court looked to the general rule that gain from the sale of a capital asset, including a partnership interest, is sourced based on the tax residence of the seller. Accordingly, the Tax Court found that a foreign partner's sale or other disposition of an interest in an ECI Partnership generates foreign source gain and should not be subject to USFIT. The outcome provoked the IRS, and ultimately prompted a swift reversal from the U.S. Congress under the TCJA.
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