In a July 13, 2017 opinion, the United States Tax Court in Grecian Magnesite Mining, Industrial & Shipping Co., SA v. Commissioner refused to follow the long-held IRS position found in Revenue Ruling 91-32 (“the “Revenue Ruling”) that a foreign person’s gain from the sale of an interest in a partnership engaged in a U.S. business is itself treated as effectively connected income (“ECI”), causing the foreign person to be subject to U.S. federal income tax on such gain. The court’s decision may prove to be very significant, as the Revenue Ruling has loomed large in the structuring of inbound investments in U.S. operating partnerships. The court determined that the ruling lacked the power to persuade and was entitled to no deference at all. The court’s decision treats the Revenue Ruling as representing the IRS’s litigating position but not as an authoritative interpretation of the law. While the decision is expected to be appealed, it could mark a significant shift in the tax law and lead to planning opportunities in the structuring of foreign investments in U.S. non-real estate operating businesses.

Background -

The U.S. federal income tax treatment of a foreign person’s sale of a partnership interest depends in large part on whether the partnership is respected as an entity separate from its partners (the “entity approach”) or, alternatively, viewed as an aggregation of its partners (the “aggregate approach”). Under the entity approach, a partnership interest is a distinct asset, separate and apart from the assets of the partnership, and accordingly the sale of the interest is treated as the sale of a capital asset, generating non-taxable foreign source income under section 865 in the case of a foreign seller that does not maintain an office or other fixed place of business in the U.S. On the other hand, under the aggregate approach, the sale would be viewed as though the partner sold its proportionate share of the property held by the partnership. That would cause a foreign seller’s gain to be subject to U.S. tax if the underlying property is used in a U.S. trade or business. It should be noted that any real estate held by the partnership is explicitly accorded “aggregate”treatment under section 897(g), so the questions raised by the Revenue Ruling and Grecian Magnesite are limited to non-real estate business assets.