Foreign Partners Victims of Tax Reform - Tax Update, Volume 2018, Issue 1

by Pepper Hamilton LLP
Contact

Pepper Hamilton LLP

More than 25 years after the IRS announced its position that foreign partners were subject to tax on the gain from the sale of the partnership interests, the Tax Court decided in favor of taxpayers. Less than six months later, Congress overturned the decision by statute in connection with the Tax Cuts and Jobs Act (the Act), which was signed into law by President Trump on December 22, 2017. This article describes the issues that foreign limited partners (LPs) are facing in light of the change in law.

Taxation of Foreign Investors in Partnerships Generally

Foreign investors generally are subject to tax in the United States only on their U.S.-source fixed or determinable annual or periodical income (FDAP), such as U.S.-source interest and dividends (but not including capital gains). The tax is imposed (by way of withholding) at a flat 30 percent (or lower treaty rate).

Partners (rather than the partnerships in which they invest) are subject to tax on their distributive share of partnership income. Additionally, the character of income recognized by a partnership (such as interest, dividends or capital gains) retains this character when allocated to the partners. Similarly, if a partnership is engaged in a trade or business, all of its foreign partners are treated as being engaged in the same trade or business. Thus, income recognized by a partnership that is effectively connected to a trade or business in the United States (ECI) flows through to foreign partners, and these foreign partners generally are subject to tax in the United States in the same manner as U.S. persons (at regular corporate or individual rates, as applicable, on net income). They also must file U.S. federal income tax returns. Foreign corporate partners may be subject to the 30 percent (or lower treaty rate) branch profits tax (BPT) in addition to regular income tax.

IRS Rulings on Sales of Partnership Interests

In 1991, the IRS issued Revenue Ruling 91-32,1 in which it concluded that the gain or loss of a foreign LP resulting from the sale of an interest in a partnership that conducts a trade or business through a fixed place of business in the United States constitutes U.S.-source ECI to the extent that the partner’s distributive share of unrealized gain or loss is attributable to property used by the partnership in a trade or business. As a result, a foreign LP would be subject to tax in the United States on the capital gain it recognizes from the sale of an interest in a partnership if the partnership is engaged in a U.S. trade or business. According to the IRS, tax treaties provided no additional protection to foreign LPs because any gain recognized on the sale of the partnership interest would be considered attributable to the partnership’s office or fixed place of business (i.e., a permanent establishment for treaty purposes) and, thus, treaties would permit the taxation of this gain as business profits.2

The Grecian Magnesite Case

The issue was recently the subject of litigation in the Tax Court.3 Grecian Magnesite Mining, Industrial & Shipping Co. is a Greek mining and industrial concern that specializes in magnesite. In 2001, Grecian became a founding member of Premier Magnesia, LLC (f/k/a Premier Chemicals LLC), which is treated as a partnership for U.S. tax purposes. Premier extracts magnesite from a mine in Nevada, manages its business through headquarters in Pennsylvania, and conducts all of its operations through offices and facilities within the United States.

On July 21, 2008, Grecian entered into an agreement with Premier to redeem its membership interest. The redemption was accomplished in two phases, each of which generated a gain. Grecian did not report any gain on its 2008 U.S. income tax return from the redemption of its interest in Premier and did not file a tax return in 2009.

On July 13, 2017, the Tax Court4 ruled that the gain was a capital gain that was not U.S.-source income and that was not effectively connected with a U.S. trade or business, thereby declining to follow Revenue Ruling 91-32. In its detailed opinion, the Tax Court was critical of Revenue Ruling 91-32, pointing to four fatal flaws in the government’s position.

IRS Position Codified

Although President Obama tried several times to codify the IRS’s position in Revenue Ruling 91-32, the change was not made. Neither the tax proposals of republican lawmakers nor President Trump’s campaign promises related to tax reform gave any indication that this was a hot issue for them. Nevertheless, when the Senate unveiled its amendments to the Act, it included a provision codifying the IRS position, and overturning (on a prospective basis) Grecian Magnesite, which became part of the final Act.

Under the Act, gain or loss on the sale or exchange of a partnership interest constitutes ECI to the extent that the transferor would have had ECI had the partnership sold all of its assets at fair market value on the date of the sale or exchange. In order to preclude foreign partners from attempting to avoid the new tax by selling in 2017, the law is effective for transfers on or after November 27, 2017.

New Withholding Tax Creates New Issues

The transferee of a partnership interest is required to withhold 10 percent of the amount realized on the sale or exchange of a partnership interest unless the transferor certifies that the transferor is not a foreign person or that none of the gain would constitute ECI. As drafted, if even $1 of the gain would constitute ECI, the transferee must withhold 10 percent of the gross proceeds from the sale. Similarly, if the gross proceeds exceed the gain on the transfer, the transferee must withhold 10 percent of the gross proceeds. If the transferee fails to withhold, then the partnership itself must do so.

This is an extreme departure from the analogous rules related to withholding on the transfer of a partnership interest where the partnership owns U.S. real estate. In that case, withholding is not even required unless at least 50 percent of the gross assets of the partnership are composed of U.S. real property interests.5 Although it is unlikely that the IRS will use its regulatory authority to limit withholding to situations where ECI assets of the partnership are so high, the IRS could provide procedures to limit withholding based on the actual amount of gain that would constitute ECI, as it has done in the Foreign Investment in Real Property Tax Act of 1980 area.

Is There Life Left in Grecian Magnesite?

The government has appealed the decision in Grecian Magnesite. The Tax Court was critical of the position in Revenue Ruling 91-32 and in the case itself. The government’s inability to cite relevant authorities or make compelling arguments strongly supports certain tax practitioners’ longstanding view that, except to the extent attributable to U.S. real property interests, foreign LPs were not taxable on gain from the sale of partnership interests before November 27, 2017. Accordingly, foreign investors that did pay tax on gain from the sale of partnership interests should consider whether the statute of limitations is still open to claim a refund for such taxes.

Pepper Perspective

The Act settles a 25-year debate over the taxation of foreign partners on the sale of partnership interests in the IRS’s favor. In doing so, it likely increases the U.S. tax burden on foreign partners that sell partnership or LLC interests (or have such interests redeemed). Blockers and alternative investment vehicles can move the tax and reporting obligations to corporate vehicles, away from the foreign partners, but this will not mitigate the ultimate tax liability, as most practitioners believed before the Act. Moreover, withholding is required on gross proceeds from the gain if even the slightest amount of gain would be ECI. The IRS has authority to reduce this burden to, for example, reduce withholding based on the actual amount of gain, though it is questionable whether the IRS will adopt a significant threshold of ECI gain before withholding is required. The IRS also will undoubtedly adopt procedures for the remission of withheld tax to the IRS, as the current procedures, which would apply to withholding by partnerships on ECI allocable to foreign partners, do not apply to withholding by transferees of partnership interests, other than those holding U.S. real property.

 

Endnotes

1 Revenue Ruling 91-32, 1991-1 C.B. 107.

2 In September 2012, the IRS Office of Chief Counsel released a memorandum reaffirming its position that a foreign partner was subject to tax on gain recognized by the foreign partner on the disposition of its interest in a partnership that was engaged in a trade or business in the United States. Field Attorney Advice (FAA) 20123903F.

3 Grecian conceded that gain attributable to U.S. real property interests held by Premier was taxable.

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

5 There is a double threshold. Not only must the 50 percent threshold be satisfied, but 90 percent of the gross assets must consist of cash, cash equivalents and U.S. real property interests before withholding is required. Temporary Regulation 1.1445-11T.

 

Written by:

Pepper Hamilton LLP
Contact
more
less

Pepper Hamilton LLP on:

Readers' Choice 2017
Reporters on Deadline

"My best business intelligence, in one easy email…"

Your first step to building a free, personalized, morning email brief covering pertinent authors and topics on JD Supra:
Sign up using*

Already signed up? Log in here

*By using the service, you signify your acceptance of JD Supra's Privacy Policy.
Custom Email Digest
Privacy Policy (Updated: October 8, 2015):
hide

JD Supra provides users with access to its legal industry publishing services (the "Service") through its website (the "Website") as well as through other sources. Our policies with regard to data collection and use of personal information of users of the Service, regardless of the manner in which users access the Service, and visitors to the Website are set forth in this statement ("Policy"). By using the Service, you signify your acceptance of this Policy.

Information Collection and Use by JD Supra

JD Supra collects users' names, companies, titles, e-mail address and industry. JD Supra also tracks the pages that users visit, logs IP addresses and aggregates non-personally identifiable user data and browser type. This data is gathered using cookies and other technologies.

The information and data collected is used to authenticate users and to send notifications relating to the Service, including email alerts to which users have subscribed; to manage the Service and Website, to improve the Service and to customize the user's experience. This information is also provided to the authors of the content to give them insight into their readership and help them to improve their content, so that it is most useful for our users.

JD Supra does not sell, rent or otherwise provide your details to third parties, other than to the authors of the content on JD Supra.

If you prefer not to enable cookies, you may change your browser settings to disable cookies; however, please note that rejecting cookies while visiting the Website may result in certain parts of the Website not operating correctly or as efficiently as if cookies were allowed.

Email Choice/Opt-out

Users who opt in to receive emails may choose to no longer receive e-mail updates and newsletters by selecting the "opt-out of future email" option in the email they receive from JD Supra or in their JD Supra account management screen.

Security

JD Supra takes reasonable precautions to insure that user information is kept private. We restrict access to user information to those individuals who reasonably need access to perform their job functions, such as our third party email service, customer service personnel and technical staff. However, please note that no method of transmitting or storing data is completely secure and we cannot guarantee the security of user information. Unauthorized entry or use, hardware or software failure, and other factors may compromise the security of user information at any time.

If you have reason to believe that your interaction with us is no longer secure, you must immediately notify us of the problem by contacting us at info@jdsupra.com. In the unlikely event that we believe that the security of your user information in our possession or control may have been compromised, we may seek to notify you of that development and, if so, will endeavor to do so as promptly as practicable under the circumstances.

Sharing and Disclosure of Information JD Supra Collects

Except as otherwise described in this privacy statement, JD Supra will not disclose personal information to any third party unless we believe that disclosure is necessary to: (1) comply with applicable laws; (2) respond to governmental inquiries or requests; (3) comply with valid legal process; (4) protect the rights, privacy, safety or property of JD Supra, users of the Service, Website visitors or the public; (5) permit us to pursue available remedies or limit the damages that we may sustain; and (6) enforce our Terms & Conditions of Use.

In the event there is a change in the corporate structure of JD Supra such as, but not limited to, merger, consolidation, sale, liquidation or transfer of substantial assets, JD Supra may, in its sole discretion, transfer, sell or assign information collected on and through the Service to one or more affiliated or unaffiliated third parties.

Links to Other Websites

This Website and the Service may contain links to other websites. The operator of such other websites may collect information about you, including through cookies or other technologies. If you are using the Service through the Website and link to another site, you will leave the Website and this Policy will not apply to your use of and activity on those other sites. We encourage you to read the legal notices posted on those sites, including their privacy policies. We shall have no responsibility or liability for your visitation to, and the data collection and use practices of, such other sites. This Policy applies solely to the information collected in connection with your use of this Website and does not apply to any practices conducted offline or in connection with any other websites.

Changes in Our Privacy Policy

We reserve the right to change this Policy at any time. Please refer to the date at the top of this page to determine when this Policy was last revised. Any changes to our privacy policy will become effective upon posting of the revised policy on the Website. By continuing to use the Service or Website following such changes, you will be deemed to have agreed to such changes. If you do not agree with the terms of this Policy, as it may be amended from time to time, in whole or part, please do not continue using the Service or the Website.

Contacting JD Supra

If you have any questions about this privacy statement, the practices of this site, your dealings with this Web site, or if you would like to change any of the information you have provided to us, please contact us at: info@jdsupra.com.

- hide
*With LinkedIn, you don't need to create a separate login to manage your free JD Supra account, and we can make suggestions based on your needs and interests. We will not post anything on LinkedIn in your name. Or, sign up using your email address.