Redemption of Foreign Corporation's Interest in U.S. Partnership Did Not Result in U.S. Source Capital Gain

(Parker Tax Publishing August 2017)

The Tax Court held that the gain realized when a foreign corporation redeemed its interest in a U.S. partnership was not U.S. source capital gain because it was not effectively connected with a U.S. trade or business. The Tax Court declined to follow Rev. Rul. 91-32, which holds that gain realized by a foreign partner on disposing of its interest in a U.S. partnership should be analyzed asset by asset, and instead applied an entity approach under Code Sec. 741. Grecian Magnesite Mining v. Comm'r, 149 T.C. No. 3 (2017).

Background

Grecian Magnesite Mining, Industrial and Shipping Co., SA (GMM), a privately owned corporation based in Athens, Greece, bought an interest in Premier Chemicals, LLC, (Premier) a Delaware limited liability company (LLC), in 2001. GMM's business included mining magnesia and magnesite in Greece. Other than through its interest in Premier, GMM had no office, employees, or business operations in the U.S. Premier, a magnesite mining company headquartered in Pennsylvania, owned mines and other properties in several U.S. states. Premier was treated as a partnership for tax purposes.

In 2001, GMM contributed $1.8 million to Premier in exchange for a 15 percent partnership interest. From March 2001 to February 2007, Premier allocated a distributive share of 15 percent of Premier's income, gain, loss and deductions to GMM. GMM's interest in Premier was reduced to approximately 12 percent in 2007 when another corporation contributed property to Premier in exchange for a 15 percent membership interest. In 2008, GMM entered into a redemption agreement with Premier for approximately $10 million. The redemption was effected by two equal payments. The first payment of approximately $5 million was made in July 2008, when GMM's basis was around $4 million, resulting in a gain of $1 million. Another partner's interest in Premier was also redeemed in July 2008, resulting in an increase of GMM's remaining proportionate interest. In January 2009, GMM received the second redemption payment when its basis was $55,000, and GMM realized gain of over $5 million. GMM and Premier agreed that the final transfer of GMM's interest was deemed to be completed in 2008 and that GMM would not share in any profits or losses in Premier or be a member after that time. The parties agreed that, of the approximately $6 million of gain GMM realized on the two payments, approximately $2 million was attributable to Premier's U.S. real estate.

Reporting on GMM's Tax Returns

GMM had its U.S. tax returns prepared by Elihu Rose, a CPA whose first foreign client was GMM. Rose prepared GMM's U.S. income tax returns for 2003 through 2008. He received Schedules K-1, Partner's Share of Income, Deductions, Credits, etc. from Premier on GMM's behalf and consulted with Premier regarding those forms. When necessary, Rose asked Premier for supplemental information in order to prepare GMM's returns. Rose received a Schedule K-1 from Premier for 2008 which reported GMM's share of Premier's income for that year. On Rose's advice, GMM did not report to the IRS any of the gain it had realized that year on the redemption of its interest in Premier. In 2009, Premier issued a Schedule K-1 for GMM with a zero balance in GMM's capital account and no income allocated to GMM for that year. On Rose's advice, GMM did not file a return for 2009.

The IRS audited GMM for 2008 and 2009, and prepared a substitute return for 2009. Deficiencies were determined for both years. According to the IRS, GMM should have recognized U.S. source capital gain of $1 million for 2008 and approximately $5 million for 2009 from the redemption of its interest in Premier. These determinations were based on the IRS's conclusion that GMM's capital gain was effectively connected with a U.S. trade or business. The IRS also found GMM liable for an accuracy related penalty for 2008 as well as for additions to tax under Code Sec. 6651 and for failure to timely file a return or pay the tax shown on the substitute return for 2009.

GMM and the IRS agreed that GMM's $1 million gain realized in 2008 from the first redemption payment and $1.2 million of the gain it realized in 2009 from the second payment were attributable to the sale of U.S. real property and were therefore U.S. source income under Code Sec. 897(g). The effect of Code Sec. 897(g) was to look through the partnership and treat GMM as the owner of its share of Premier's U.S. real property assets. GMM acknowledged that the gain attributable to those interests was effectively connected with the conduct of GMM's trade or business and was therefore subject to U.S. income tax. However, the parties disputed whether the remaining gain of approximately $4 million was U.S. source income that was effectively connected with a U.S. trade or business under Code Sec. 882.

Taxation of Foreign Corporations and Liquidations of Partnership Interests

Under Code Sec. 736(b)(1), payments received in liquidation of a partnership interest are made in exchange for a partner's interest in partnership property and are therefore a distribution by the partnership. The gain on such a distribution is treated under Code Sec. 731 as gain from the sale or exchange of a partnership interest. Under Code Sec. 741, the gain from the sale of a partnership interest is generally treated as gain from the sale of a capital asset.

Code Sec. 882 provides that a foreign corporation is taxed in the U.S. on income that is effectively connected with the conduct of a U.S. trade or business. Effectively connected income is defined in Code Sec. 864(c)(3) as all income from sources within the U.S. The source rule in Code Sec. 865 provides that the sale of personal property by a nonresident generally results in non-U.S. source income. However, under the U.S. office exception in Code Sec. 865(e)(2)(A), income from the sale of personal property attributable to a U.S. office is U.S. source income. The U.S. office exception applies only if the U.S. office (1) is a material factor in the production of the income and (2) regularly carries on activities of the type from which the income is derived.

GMM and IRS Positions

GMM contended that an entity approach to partnership taxation should apply, meaning that the gain from the liquidation of its interest in Premier arose from the sale of a single asset, the partnership interest, as opposed to GMM's share of the underlying assets. According to GMM, the sale of a partnership interest is treated as the sale of an indivisible item of intangible personal property under Code Sec. 741 and may not be recharacterized as the sale of separate interests in each asset owned by the partnership. GMM argued that it was not subject to U.S. tax on the sale of the partnership interest because the income (not including the income from Premier's U.S. real property interests) was not U.S. source income and not effectively connected with the conduct of a U.S. trade or business.

The IRS argued that under an aggregate approach, GMM's gain arose from the sale of its interest in the assets that made up Premier's business and that the gain was effectively connected with GMM's conduct of a U.S. trade or business under Code Sec. 882. In defense of its argument for the aggregate theory, the IRS asserted that if Code Sec. 741 required that the redemption of a partnership interest be treated as the sale of an indivisible asset, then Code Sec. 897(g) would be inoperable. That is, the sale of a partnership interest could not be both (1) the sale of an indivisible asset, and (2) a sale of U.S. real property interests and of a partnership interest, as required by Code Sec. 897(g). To reconcile the two, the IRS argued that the court should interpret Code Sec. 741 as applying only to the character of the gain recognized (capital, rather than ordinary).

Tax Court's Decision

The Tax Court rejected the IRS's arguments for the aggregate theory and held that GMM's gain was non-U.S. source gain from the sale of an indivisible capital asset. There were four flaws in the IRS's argument, according to the Tax Court. First, the IRS exaggerated the conflict between the entity theory in Code Sec. 741 and the aggregate approach to U.S. real property interests in Code Sec. 897(g). The court read Code Sec. 741 as a general rule that allows exceptions, not a rule of absolute and universal application. Second, Code Sec. 741 provides that the gain realized on the sale of a partnership interest is gain from the sale of a capital asset; in the court's view, the singular wording was more consistent with the entity theory. Third, the Tax Court reasoned that the existence of the exceptions to Code Sec. 741 for receivables and inventory items and for U.S. real property interests would be superfluous if Congress intended Code Sec. 741 as a lookthrough provision. Fourth, Code Sec. 731(a) made it clear to the Tax Court that the entity theory generally applies to a partner's gain from a distribution. The operation of Code Secs. 736(b)(1), 731(a), and 741 led the Tax Court to the conclusion that the gain from the sale of a partnership interest was gain from the sale of a singular capital asset.

Next, the Tax Court determined that GMM's gain was not effectively connected with the conduct of a U.S. trade or business under Code Sec. 882. In doing so, the court declined to follow the IRS's approach in Rev. Rul. 91-32. The ruling holds that gain realized by a foreign partner on the disposition of its interest in a U.S. partnership should be analyzed asset by asset, and that, to the extent the assets of the partnership would give rise to effectively connected income if sold by the entity, the departing partner's pro rata share of such gain should be treated as effectively connected income. The Tax Court found the reasoning of Rev. Rul. 91-32 cursory, and noted that it failed even to cite Code Sec. 731. The court declined to defer to the ruling and instead applied the Code and the regulations to determine whether the disputed gain was effectively connected income.

The Tax Court determined that as a nonresident, GMM's sale of its interest in Premier resulted in non-U.S. source income. It also determined that the U.S. office exception did not apply. For the exception to apply, the Tax Court found, Premier's U.S. office had to be material to GMM's gain realized on the redemption rather than simply being a material factor in ongoing, distributive share income from regular business operations. The Tax Court concluded that under the regulations, Premier's general efforts to develop, create or add value to the property sold were not a material factor in the realization of the disputed gain. Likewise, the performing of merely clerical functions by Premier incident to the sale was also not a material factor. The Tax Court further found that the redemption of GMM's interest in Premier was an extraordinary event, and that the resulting gain was not realized in the ordinary course of Premier's business of producing and selling magnesite products.

Finally, the Tax Court held that GMM was not liable for the substantial understatement penalty under Code Sec. 6662(d) or for additions to tax under Code Sec. 6651 for its failure to report the U.S. real property gain on its 2008 return and for its failure to file a 2009 return and pay the 2009 tax because it had reasonable cause. The court found that GMM's accountant, Rose, was a competent professional tax adviser, that GMM provided necessary and accurate information to him, and that GMM actually relied in good faith on Rose's judgment.

For a discussion of payments in exchange for a partner's interest in partnership property, see Parker Tax ¶23,550. For a discussion of the tax on effectively connected income of foreign corporations, see Parker Tax ¶201,120. For a discussion of the reasonable cause exception for avoiding penalties for substantial underpayments, see Parker Tax ¶262,120.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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