On July 13, 2017, the US Tax Court rejected the IRS position requiring foreign investors in US operating partnerships to pay tax on the gains derived from the sale of partnership interest.
While creating some additional uncertainty regarding the taxation of cross-border investment into the United States, the surprise ruling also created noteworthy inbound tax planning opportunities for foreign individuals seeking to invest in the US marketplace.
In Grecian Magnesite Mining, Industrial & Shipping Co., SA, v. Commissioner of Internal Revenue, the Tax Court rejected the IRS’s position in Revenue Ruling 91-32.
Revenue Ruling 91-32 deemed gains derived on the sale of an interest in a partnership operating a US trade or business as subject to US federal income tax, regardless of the residence of the investor. In other words, it treated any sale of interest in a US partnership as the sale of US business assets, and therefore taxable by the federal government, even if the seller wasn’t a US citizen or resident.
Tax Court Decision
In overturning Revenue Ruling 91-32, the Tax Court reasoned that such a disposition should instead be considered the sale of a capital asset by a foreign person. As such, it wouldn’t generally be subject to US federal income tax.
Although the IRS appeared to believe its position was unimpeachable, the Tax Court offered no deference to the IRS’s long-standing position, stating that “Revenue Rule 91-32 isn’t simply an interpretation of the IRS’s own ambiguous regulations, and we find that it lacks the power to persuade.” In doing so, the Tax Court came down firmly on the side of the entity theory of partnerships, openly unconvinced by the IRS’s logic in applying the aggregate theory to the sale of a partnership interest.
The Tax Court’s ruling offers potential tax benefits for foreign investors in US partnerships because the disposition of a partnership interest creates gain that, according to the Tax Court, should be sourced to the residence of the seller, not the US location of the business. This means the sale of a partnership interest by a foreign person would generally be foreign-source income and should generally be exempt from US federal income tax, with some exceptions, such as those pertaining to the sale of real property.
How far reaching, or long lasting, the effects of the Tax Court ruling will be remains to be seen. A likely short-term effect may be a flurry of foreign investors filing claims for refunds on taxes paid on recent US partnership dispositions.
Longer term, the ruling appears to open new structuring options to inbound investors. For a foreign investor, investment in a US business structured in partnership form may allow start-up losses to pass through to the investor, allowing the investor to use those losses to offset income from other profitable US investments.
At the same time, any capital gain realized upon exit may completely avoid US taxation. At least for now, it seems that foreign investors may be able to benefit from their losses while avoiding tax on their exit gains. It waits to be seen whether this condition is permanent or if it’ll be resolved by congressional legislation or more specific US Treasury regulations.
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For more information about how the new ruling may impact future tax planning, contact your Moss Adams professional.
Thanks to Ryan Schuh for his assistance drafting this article.