Dispositions of Partnership Interests by Foreign Partners

By Magda Szabo

While codification exists for the aggregate tax treatment of certain specified transactions and specified “hot” assets, such as unrecognized receivables, depreciable assets to the extent of allocable gain and certain appreciated inventory,¹ other areas are defined more broadly, such as partnership income when the U.S. office of a partnership is material to its production as generating income sourced to the United States.²

Revenue Ruling 91-32

Twenty-six years ago, the Internal Revenue Service issued Revenue Ruling 91-32, which held that: (1) when a partnership is engaged in U.S. activity, its partners are likewise deemed to be engaged in U.S. activity per Internal Revenue Code Section 875(1); and (2) income passed through to a foreign partner is sourced to the United States, when and to the extent the partnership is engaged in U.S.-sourced activity. Without focusing on any codified distinctions between pass-through income and gain on disposition of partnership interests in Subchapter K, the ruling essentially concluded that gain on disposition of partnership interests by a foreign partner is sourced to the United States to the extent that the partnership’s underlying assets generated U.S.-sourced income.

In short, the IRS applied an aggregate view of partnership gain, both for sourcing pass-through income and again gain on disposition for purposes of Subchapter N. Given the lack of detailed analysis, the ruling has been criticized by practitioners since its issuance. A number of practitioners have opted through the years not to follow it but, curiously, the matter wasn’t litigated until this year.             

Grecian Magnesite Mining, Industrial & Shipping Co., S.A.

On July 13, 2017, in a lengthy opinion, the Tax Court in Grecian Magnesite Mining, Industrial & Shipping Co., S.A. v. Commissioner 149 TC 3 (2017), refused to follow Rev. Rul. 91-32, stating that the ruling improperly interprets the text of relevant statutes and has inadequate reasoning. The case technically involved the redemption of Grecian Magnesite’s interest in a domestic partnership in the form of two liquidating distributions. The partnership was actively engaged in U.S.-based business activity.

The opinion started with IRC Section 741, which provides that the sale of a partnership interest is deemed to be that of a capital asset: an entity view of a partnership disposition transaction, save for explicit statutory exceptions. The paramount exception is IRC Section 751, which imposes an aggregate view for specified “hot” assets previously noted on disposition of partnership interests. Apparently, this type of property wasn’t at issue in the case, hence it wasn’t explicitly addressed.

The court noted that IRC Section 897, FIRPTA,³ explicitly sources gain on sale of U.S. real estate, whether capital or otherwise, to the United States with specified “look through” rules applying in a partnership setting.  Hence, to the extent U.S. real property is held, or deemed to be held,⁴ an aggregate view of the gain for sourcing purposes applies and tax withholding is required.⁵

For income and transactions not subject to FIRPTA, the court noted that the default sourcing rule for capital gains is found in IRC Section 865, which, subject to certain specified exceptions, generally sources capital gains per residency. An exception delineated in the statute is for “any income from the sale of personal property (including inventory) attributable to such office or fixed place of business.”⁶

The IRS argued that gain is allocable to the United States because appreciation in value of the partnership interests disposed of arose from a U.S. office or “fixed place of business.” However, the court determined that said “office or fixed place of business” wasn’t an essential economic element in the realization of income in this instance because the specific transaction involved a redemption (disposition) of partnership interests as opposed to a transaction generating gain within the partnership as part of its ongoing U.S. business activity. 

In short, because provisions Sections 865 and 864 don’t specifically provide for aggregate treatment of this type of transaction, the default entity view provisions on sale or disposition of partnership interests per Section 741 were found to apply. Furthermore, given that the gain is capital, the default income sourcing rules Section 865 apply as Section 864 doesn’t explicitly provide for U.S. sourcing. Hence, the gain is sourced based on residency of the recipient, which in this case is offshore. 

While Grecian Magnesite was a taxpayer win, this victory was short-lived. The key element to the court decision was a lack of specific statutory provision in Sections 865 and 864 mandating aggregate treatment for disposition of partnership interests. Such a codification had been proposed during 2012, as part of the Obama administration’s 2013 budget proposal. The proposal included a mandatory 10 percent withholding tax on disposition of foreign partner interests. However, the proposal didn’t gain support at the time, possibly given the lack of case law contradicting the ruling. 

Senate Bill

As a direct reaction to the recent Grecian Magnesite decision, the Senate incorporated into its 2017 tax bill an explicit provision, which was finalized largely as proposed, that gain or loss from the sale or exchange of a partnership interest is effectively connected with a U.S. trade or business and hence sourced to the United States to the extent that the transferor would have had effectively connected gain or loss had the partnership sold all of its assets at fair market value as of the date of the sale or exchange. Any gain or loss from the hypothetical asset sale by the partnership is be allocated to interests in the partnership in the same manner as non-separately stated income and loss.       

As with the original Obama proposal, partnership transferees are now also required to withhold 10 percent of the amount realized unless the transferor partner certifies he’s not a nonresident alien or, if a corporation, not a foreign corporation. If the transferee fails to withhold, the partnership is required to deduct and withhold on future distributions to the transferee partner the 10 percent amount that should have been withheld on transfer. The specific amendment was incorporated into Sections 864 and 865, as well as IRC Section 1446.  The provisions are effective for sale or dispositions occurring on or after Nov. 27, 2017; withholding for dispositions on or after Dec. 31, 2017. U.S.Treasury is charged with implementation.⁷

Transfer Taxation

Turning to transfer taxation, there are currently no specifically codified provisions addressing the tax treatment of partnership interests held at the death by nonresident aliens when partnerships are engaged in a U.S.-sourced business activity.⁸ In general, Subchapter B of Subtitle B (Chapter 11) addresses estates of “nonresidents not citizens,” providing that the part of gross estate of such individuals situated in the United States is subject to estate tax.

The relevant statutes provide guidance as to the situsing of stock, debt, mutual funds, art and deposits. Specifically, holders of U.S. corporate stock upon death fall within the purview U.S. tax inclusion.⁹ However, the statutes don’t address partnerships per se, and hence there’s little guidance save for old Rev. Rul. 55-701, which provides that a partnership interest is deemed situated where the partnership’s business is carried on and not where the holder is resident. Similarly, an aggregate view was taken for estate taxes in a very old decision in which a deemed foreign partnership holding U.S. assets was dissolved due to the death of a nonresident alien partner (though the dissolution can be viewed as distinct from merely holding an interest at death).¹⁰

Gift Tax Treatment

The gift tax treatment relative to nonresident aliens holding partnership interests is likewise unclear—and it doesn’t appear the IRS will be providing clarification in the near future. Last year, the IRS, in Revenue Procedure 2016-7, indicated that it won’t issue rulings on this topic. For gift tax purposes, the exempt status of corporate stock is explicitly addressed by statute when a distinction between transfers of interests by gift versus on death exists.¹¹ However, to the extent an aggregate view exists as to partnerships, parallel treatment between corporate stock and partnership interests is less likely to find support.   

To the extent an entity view of partnership interests is found for transfer tax purposes, a claim of exemption from gift tax is possible. To the extent income tax legislation specifies an aggregate view of partnership interests for effectively connected income, a greater concern exists that an aggregate view is similarly appropriate for transfer tax purposes.¹² For planning purposes, while uncertainty remains, greater support for an aggregate view on transfer of partnership interests now exists. 

Clarity Needed

The oscillating and evolving treatment of partnership interest disposition by foreign partners highlights the difficulty of resolving the entity versus aggregate components of pass-through entities. Increased offshore ownership of such interests has created additional complexity relative to tax treatment. For decades, the only answer was an inadequately drafted revenue ruling recently overturned by a Tax Court decision. While new legislation has yet to be fully implemented, at least greater definition as to tax treatment now exists for income tax purposes. Similar clarity is still needed relative to transfer taxes when nonresidents in nontreaty countries still have only a scant $60,000¹³ estate tax exemption, and unlike for U.S. citizens and domiciliaries, no increase in exemption amounts were incorporated in the Tax Cuts and Jobs Act of 2017. Nevertheless, Congressional reaction to Grecian Magnesite appears to make it less likely that legislation or even future IRS pronouncement would move in a different direction for transfer taxes.  

Endnotes

1. See IRC § 741 (gain on disposition of a partnership interest is capital gain) vs. IRC § 751 (detailing ordinary income treatment to the extent of a pro rata share of specified partnership assets).
2. See IRC §§ 765, 864; Treas. Reg. § 1.864-4.
3. An acronym for “Foreign Investment in Real Property Tax Act” promulgated in 1980.
4. FIRPTA provisions impose certain “look through” rules for both partnerships and corporations that sets aside entity structure. 
5. FIRPTA imposes tax liability as withholding on gross proceeds.
6. See IRC § 865(e)(2)(A), which specifically provides that if a “nonresident ... maintains an office or fixed place of business in the United States, income from the sale of personal property … attributable to such office or other fixed place of business shall be sourced to the United States.”
7. Notably, Notice 2018-8, issued Jan. 2, 2018, temporarily suspended the withholding requirements of IRC § 1446(f) as applicable to publicly traded partnerships, as implementation relative to PTPs creates significant issues. The Notice suspended the application of the withholding rules until Treasury Regulations, pending public comment, are issued. The Notice explicitly asked for public comment.  
8. The one notable exception is FIRPTA, discussed previously. Curiously, corporate stock ownership is explicitly addressed, IRC §§ 2501, 2511.
9. See IRC §§ 2103, 2104.
10. See Sanchez, Frederico Est. v. Bowers (1934, CA2), 13 AFTR 1074, 70 F2d 715. 
11. See IRC §§ 2501, 2511.
12. Section 2103, read in concert with §§ 2104, 2105 and 2031, doesn’t exempt U.S. interests per se because they’re intangibles. 
13. See § 2102 according a $13,000 credit, which translates into an exemption amount of $60,000.

Magda Szabo, CPA, JD, LL.M, is a Tax Partner at Janover LLC.