Tax Court Holds Gain From the Liquidation of a Foreign Partner’s Ownership Interests In a U.S. Partnership Actively Engaged in Business in the U.S. Is Not Effectively Connected Income

By: Jerald David August

Grecian Magnesite Mining, Industrial & Shipping Co., SA v. Commissioner, 149 T.C. No. 3  (July 13, 2017)

In 2001 Grecian Magnesite Mining, et al (“GMM”), was organized in 1959 under the laws of Greece (the Hellenic Republic) and maintained its principal place of business at the time it filed its petition with the Tax Court in Athens, Greece. GMM's business includes extracting, producing, and commercializing magnesia and magnesite, which it sells to its worldwide customer base. GMM owns magnesite deposits in Greece, has a research and development facility in Greece, and has an office in Greece. Other than through its ownership interest in a Delaware limited liability company, Premier Magnesia, LLC (“Premier”),[1] GMM had no office, employees, or business operation in the United States.

GMM purchased an interest in Premier in 2001. Premier is treated as a partnership for U.S. income tax purposes.[1] GMM made an initial capital contribution to Premier of $1.8M for a 15% interest in the company. From 2001 to 2008 income GMM was allocated 15% of Premier’s income, gain, loss and deductions from the U.S. operations conducted by Premier. In 2007 another corporation contributed property to Premier for a 15% membership interest whereupon GMM’s membership interest in Premier was reduced to 12.6%.

In 2008 one of Premier’s members approached Premier and offered to sell to Premier its entire membership interest for $10M to which Premier agreed. However, Premier was contractually obligated to offer to purchase each member’s interest for the same pro rata price that Premier had paid to the third party.  GMM was the only other partner that chose to sell its interest.

On July 21, 2008, GMM contractually agreed for Premier to redeem its 12.6% interest for $10.6M. GMM received the first redemption payment of $5.3M on July 31, 2008 in exchange for one-half of its partnership interest. On July 31, 2008, GMM’s adjusted basis in its membership interest was $4.3M and therefore realized a $1M gain on the first redemption.

On January 2, 2009, GMM received the second payment of $5.3M from Premier realized a gain of over $5.2 million in completing the redemption of its ownership interest. Premier and GMM agreed that the effective date of the final transfer of GMM's remaining 6.3% interest in Premier was deemed to be December 31, 2008, and that GMM would not thereafter share in any profits or losses in Premier or otherwise be deemed a member of Premier. The parties also agreed that, of the $6.2 million of gain that GMM realized in the two payments, $2.2 million (i.e., the entire $1 million of the first payment and $1.2 million of the second) was attributable to Premier's U.S. real estate. This in turn meant that the gain was taxable in accordance with §897 as effectively connected income. GMM argued at trial that the remainder of the gain, $4M, is not taxable for U.S. purposes.

GMM timely filed a Form 1120–F, “U.S. Income Tax Return of a Foreign Corporation”, for 2008, wherein it reported its distributive share of Premier's income, gain, loss, deductions, and credits, but did not report any income it received from the redemption of its partnership interest which it later conceded was U.S. source income to the extent of gain attributable to U.S. real property interests in accordance with §897.  GMM did not file a return or pay any income tax in the United States for 2009. GMM's reporting position was recommended to it by an experienced certified public accountant who was recommended to GMM by its U.S. lawyer.

The IRS prepared a substitute for return pursuant to  § 6020(b) for GMM's 2009 year, and issued a notice of deficiency for 2008 and 2009, determining, inter alia, that GMM must recognize its gain on the redemption of its partnership interest for U.S. tax purposes as U.S.-source income that was effectively connected with a U.S. trade or business, consistent with Rev. Rul. 91–32, 1991-1 C.B. 107. The IRS concluded that GMM’s capital gain was effectively connected with a trade or business engaged within the U.S. The substitute return also determined that for 2008 GMM was liable for an accuracy-related penalty and for 2009 was liable for penalties for failure to file and failure to per §§6651(a)(1) and 6651(a)(2).

GMM Files Tax Court Petition

GMM timely filed a petition with the U.S. Tax Court.  As previously mentioned, GMM started off with a partial concession which the government agreed. The parties were still in dispute whether the remaining gain from the redemption of GMM's interest in Premier, approximately $4 million, is U.S.-source income that is effectively connected with a trade or business in the United States and thereby subject to taxation in the United States.

Since the government’s notice of deficiency was entitled to a presumption of correctness, GMM, as petitioner, had the burden of proving that the position taken by the government was wrong. [2] Still, since the income was omitted from GMM’s returns, the Commissioner is required to offer some substantive evidence showing that the taxpayer received income from the charged activity. [3]

Whether the residual or non-FIRPTA gain is effectively connected with a U.S. trade or business was the main issue to be decided by the Court. See §§882(a)(1), 864(c). 

The Tax Court in its opinion, which was issued by Judge Gustafson, first looked at the applicable rules pertaining to distributions in redemption of partnership interests including §736(b)(1)(“exchange” treatment), §736(a) (effectively treated as a “distribution” from the sale or exchange), §741 (recognition and character of gain or loss on sale or exchange of partnership interest), and the “hot asset” rule of §751(a). The petitioner-GMM had argued that as to the non-FIRPTA gain, §741 should be determinative and that if the asset was held by GMM as a capital asset, the “entity theory” of partnership taxation required that none of the gain be treated as involving the sale of the underlying assets of Premier.  This position would them be applied in conjunction with §865(a)(2) which provides that gain from the sale of personal property, here intangible personal property, by a nonresident is sourced outside of the United States (unless there is a specific exception).

The government countered that §741 can not be applied in a manner which ignores other provisions in the Code that require that the sale of a partnership interest apply the “aggregate theory” of partnership taxation. Such would include application of §865 which provides source rules for personal property sales, including, the exception for sales of inventory property and depreciable personal property under §865(b) and §865(c). Like §897, §865 is outside of Subchapter K and can not be ignored in addressing the characterization of gain from the sale of a partnership interest. Judge Gustafson resolved whether the residual gain realized in the redemption was from the sale of a single asset of personal property or should be subject to a look-thru approach as if the partnership sold its assets at the time of the redemption.  The Tax Court, as is noted below, stated the redemption involved the sale of a single asset as required under §§736(b)(1), 731 and 741. 

Next, the Court referred to §882 to determine if the gain from the sale of personal property was ECI. Premier, which was engaged for the years in issue in a U.S. trade or business, imputes its U.S. trade or business status to a non-resident partner by §875(l).[4]  Next, §864(c)(3) provides that “all income, gain, or loss from sources within the United States”, other than FDAP income, is ECI with a trade or business within the United States. [5]

Service’s Reliance Upon Rev. Rul. 91-32, supra.

Rev. Rul. 91-32, supra, provides that gain or loss of a foreign partnership from a disposition of an interest in a partnership which conducts a trade or business through a fixed place of business or has a permanent establishment in the U.S. constitutes U.S. effectively connected income with respect to such trade or business by applying a deemed asset (by asset) sale approach. Accordingly, based on this deemed asset sale construct,  to the extent the disposition of the partnership’s assets would give rise to ECI if sold by the entity, then the departing non-resident partner is treated as realizing ECI with respect to the gain from the disposition of its partnership interest. Factors used to determine ECI gain or loss apply  §864(c)(2) include whether the gain or loss is derived from an asset that is used or held for use in the conduct of a trade or business in the United States, or whether the activities of that trade or business were a material factor in the realization of the gain or loss. Treas. Reg. § 1.864-4(c)(2) provides direct guidance on whether an asset is used or held for use in the conduct of a trade or business within the United States. Treas. Reg. § 1.864-4(c)(3) determines the character of gain or loss realized directly from the active conduct of the trade or business.

The Court noted the Ruling effectively extended the reach of the hot-asset rules in §751 from simply inventory and receivables to an entire category of assets, assets used in a U.S. trade or business versus assets that were not effectively connected with a U.S. trade or business. Notwithstanding the non-ambiguity of §751(a), Chief Counsel argued that this Ruling should be given “appropriate deference”.[6]

The Court noted the Tax Court’s long-standing precedent on how much weight should be given to agency interpretations of the tax law and that any deference to be granted would depend on the particular regulations or rules before the Court which the administrative agency has interpreted.  See Rand v. Comm’r, 141 T.C. 376, 380-381 (2013); PSB Holdings, Inc. v. Comm’r, 128 T.C. 131, 145 (2007).  The level of deference depends on the degree that a regulation suffers from ambiguity. Of course, no deference would be given if a ruling sets forth  an erroneous interpretation of the law.

Tax Court Rejects Service’s Application of Rev. Rul. 91-32, supra.

Judge Gustafson, after setting out the arguments before the Court made by counsel for GMM and the Service, held that Rev. Rul. 91-32, supra is simply not an interpretation of the IRS’s own ambiguous regulations and we therefore find it lacks the power to persuade. It essentially ignores the construct of Subchapter K. No deference was granted.

Tax Court Resolves The Issue Before It By Application of Sections 861-863 and 865

The issue before the Court was how to apply the ECI and sourcing rules in general to a liquidating distribution of a foreign partner’s interest in a U.S. partnership, which again involves a taxable exchange of personal property. Under §865(a)(2),  gain from the sale of personal property is foreign source income when realized by a nonresident. That was indeed GMM’s position. The Service, having failed in its efforts to persuade the Court that Rev. Rul. 91-32, supra controlled the issue, next argued the “U.S. office rule” under §865(e)(2)(A) results in taxable gain. Section 865(e)(2)(A) provides that “[I]f a nonresident maintains an office or other fixed place of business in the United States, income from any sale of personal property (including inventory property) attributable to such office or other fixed place of business shall be sourced in the United States.” As applied to the facts, the Service’s position was that the liquidation gain of GMM was wholly attributable to Premier’s office maintained in the U.S. and that should be deemed to be GMM’s U.S. office. This argument is along the lines of §875(l). After all, the Service contended, the entire gain that GMM realized was attributable to Premier’s business operations.

In applying §865(e)(2)(A), §865(e)(3) provides a rule of construction. Section 865(e)(3) provides that in order to determine whether income from a sale is attributable to a U.S. office or fixed place of business, the principles under §864(c)(5) shall apply. (emphasis added).[7]  Under §864(c)(5)(B), income or gain is attributable to a U.S. office only if: (a) the U.S. office is “a material factor in the production of such income”, and (b) the U.S. office “regularly carries on activities of the type from which such income, gain, or loss is derived.” Treas. Reg. §1.864-6 refers to these two elements together as the “material factor” test, explaining “regularly carries on activities of the type”, see §864(c)(5)(B), as “realized in the ordinary course”. The Court viewed the meaning of “regularly carries on activities of the type…” was an “ordinary course” of business standard. Still, the Tax Court noted that it was not provided with a regulation that defines what tax items of income, gain or loss are “attributable to” an office or other fixed place of business in the U.S. and that the law in this area does not set out a “clear, objective standard”. See Treas. Reg. §1.864-6(b)(1) (“material factor”). 

In carving out its own standard for applying principles under §865(e)(3), the Court adopted a “material factor” that is “significant” and “essential” in whether the income or gain was attributable to a U.S. office or fixed placed of business in the U.S. In other words, the U.S. office must be material to the gain realized from redemption transaction itself. The Court again rejected the government’s additional attempt, this time under §864(b)(5)(B), to apply what it viewed as a deemed asset sale  approach.

GMM argued that Treas. Reg. §1.864-6(b)(2)(i) supported its position and that Premier’s efforts to increase its value as a going concern did not, per se, establish that GMM’s realization of gain is attributable to Premier’s office. [8]

The Service argued that this regulation relied upon by GMM pertained to rents, royalties or gains on sales of intangible property and not specifically with respect to gain from the redemption of a partnership interest. While the Court agreed with the Service’s position on -6(b)(2)(i), it again made reference that §865(e)(3) instructs to not directly apply the rules and regulations under §864(c)(5) which by its terms do not apply to a redemption of a partnership interest, but to apply the principles of §864(c)(5). (emphasis added). Again, the Court once more stated that there is no regulation on point to apply in this case.

Faced with this perplexing Code and regulatory landscape, the Court held that the material factor test is not satisfied based on the record before it because Premier’s actions to increase its overall value were not an “essential economic element in the realization of the income”. Treas. Reg. §1.864-6(b)1). Adding value to business goodwill alone not a material factor and simply liquidating a partnership interest is not either. Thus, the Tax Court concluded, that Premier's efforts to develop, create, or add substantial value to the property sold are not considered to be a material factor in the realization of the disputed gain pursuant to Treas. Reg. §1.864–6(b)(1). Therefore, the Service failed to show that the first test for attributing the disputed gain to a U.S. office—“material factor”—is met.

The Tax Court took another opportunity to reject the government’s argument by stating that the second part of the gain attributable to a U.S. office test was also not established under the facts. The redemption was an extraordinary event and therefore could not be considered to be in the “ordinary course” of Premier’s business. Judge Gustafson reflected the Court’s rather formalistic view  that Premier indeed was in the course of producing and selling magnesite products but that the gain realized by GMM on the redemption of its partnership interest was not realized in the ordinary course of the trade or business carried on through Premier’s U.S. offices. [9]

Service’s Proposed Accuracy and Late Filing/Payment Penalties Abated

The Court further held that the taxpayer’s reliance on the CPA advice not to file returns reporting the redemption gain was reasonable and in good faith and that it was not subject to an accuracy related penalty for 2008 or a failure to file or failure to pay penalty for 2009. 

Concluding Thoughts.

The Tax Court’s decision in Grecian Magnesite Mining, Industrial & Shipping, Co., SA v. Commissioner, supra, may indeed come as a surprise to many tax advisors of non-resident persons holding interests in U.S. partnerships. With a long-standing ruling in place that obviously many taxpayers had followed for over 25 years now being discarded by a full decision of the Tax Court, those who have paid tax in recent years based on complying with Rev. Rul. 91-32, supra, should consider filing a claim or claims for refund for a prior year(s) overpayment in U.S. income tax. That also may affect the foreign taxpayer’s tax credit position in its home country as well that could produce an offsetting detriment. Given that U.S. tax rates on ECI are higher than most countries that impose a tax on income of its residents, there should be net savings from a refund claim. For a treaty country resident the result is “all good” as the phrase is used in certain contexts.

The holding of the Court simply elevates redemptions of foreign partners’ partnership interests (not otherwise subject to FIRPTA) over asset sales by U.S. partnerships engaged in a U.S. trade or business having foreign partners. While it invites regulations to be issued inasmuch as it repeatedly stated there was no regulation on point only “principles” to be applied under §865(e)(3), for now it appears non-residents investing in U.S. partnerships engaged in business operations have a favorable cash-out strategy that many may not have felt was available before, at least without having to make a form of disclosure to avoid a penalty if the position would later be defeated.

Will the government appeal the decision? That isn’t quite certain as of yet but a notice of appeal must be filed within 90 days after the Tax Court decision is entered. Will the Service nevertheless issue a notice of non-acquiescence?[10]  What about other courts of applicable jurisdiction, including Circuit Courts of Appeal?

[1] Premier is in the business of extracting, producing, and distributing magnesite which it mines or extracts in the United States. During the years in issue, the office of Premier's headquarters was in Pennsylvania, and it owned mines or industrial properties in various States, including Nevada, Florida, and Pennsylvania.

[2] Welch v. Helvering, 290 U.S. 111 (1933). T.C. Rule 142(a).

[3] Weimerskirch v. Commm’r, 596 F.2d 358 (9th Cir. 1979), rev’g 67 T.C. 672 (1977).

[4] Unger v. Comm’r, T.C. Memo. 1990-15; Donroy, Ltd., et al, v. U.S., 301 F.2d 200 (9th Cir. 1962).

[5] The Service considered that the source of attraction rule in §864(c)(4)(B) was not involved).

[6] The three scenarios involved in Rev. Rul. 91-32 involve a “sale” and a “disposition” of a partnership interest and not a “liquidation” of a partnership interest as involved in this case but the Court felt that this distinction was immaterial.

[7] As noted by the Court in fn. 20 “By its terms, section 864(c)(4)(B) and (c)(5) does not apply to gains from dispositions of partnership interests, because such gains are not one of the three types of income denoted in section 864(c)(4)(B)(i)-(iii). Thus, section 865(e)(3) does not incorporate section 864(c)(5) per se but rather invokes only “[t]he principles of section 864(c)(5)”.

[8] Treas. Reg. §1.864-6(b)(2)(i) provides:

“An office or other fixed place of business in the United States shall not be considered to be a material factor in the realization of income, gain, or loss for purposes of this subdivision merely because the office or other fixed place of business conducts one or more of the following activities: (a) Develops, creates, produces, or acquires and adds substantial value to, the property which is leased, licensed, or sold, or exchanged, (b) collects or accounts for the rents, royalties, gains, or losses, (c) exercises general supervision over the activities of the persons directly responsible for carrying on the activities or services described in the immediately preceding sentence, (d) performs merely clerical functions incident to the lease, license, sale, or exchange or (e) exercises final approval over the execution of the lease, license, sale, or exchange.”

[9] Another argument that was not required to be made before the Court was the Petitioner’s claim that the non-FIRPTA gain from the redemption was not subject to tax under the Greece-U.S. Income Tax Treaty. See e.g., Article III (Business Profits) in that the treaty would override application of §864(c) in the context of a redemption of a partnership interest.

[10] See I.R.M. (Standards Governing Issuance of AODs). 

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