Tax Planning for Foreign Investors Investing in Partnerships with Income Effectively Connected to a US Trade or Business
A recent US Tax Court case may provide an investment opportunity for foreign investors investing in US partnerships. On July 13, 2017, the Tax Court ruled in Grecian Magnesite, Mining, Industrial and Shipping S.A. v. Commissioner (149 T.C. No. 3 (July 13, 2017)) (“Grecian Magnesite”) that a foreign partner’s capital gain from the sale of an interest in a partnership that is engaged in a US trade or business is treated as foreign source income and thus is not subject to US federal income tax. Ruling in favor of the foreign partner, the court declined to follow Rev. Rul. 91-32 which provides that the gain realized by a foreign partner from the sale of an interest in a US partnership is taxable to the extent the assets of the partnership would give rise to ECI (i.e., income effectively connected with a US trade or business). The court’s ruling in Grecian Magnesite provides a great opportunity for foreign investors to avoid capital gains tax on the sale of their US partnership interests. There are some caveats, but overall this is a great planning opportunity.
Rev. Rul. 91-32
Rev. Rul. 91-32 provides that the gain by a foreign partner from the sale of a partnership interest is considered effectively connected with a US trade or business to the extent of the partner’s distributive share of unrealized gain of the partnership that is attributable to property used or held for use in the partnership’s trade or business in the US (“ECI asset”).
Rev. Rul. 91-32 provides that if the partnership is engaged in a US trade or business and maintains a US fixed place of business, the entire gain on the sale of the partnership interest is ECI because the partnership interest itself was an ECI asset. In another situation, if the partnership is engaged in a US trade or business and it has both ECI assets and non-ECI assets, the partner’s distributive share of each type of gain would first be determined in the event of a hypothetical sale of all the partnership assets and only the capital gain on the sale of the partnership interest attributable to the net ECI gain would be taxable to the foreign partner.
However, no Internal Revenue Code (“IRC”) provision explicitly provides that gain from the sale or exchange of a partnership interest by a foreign investor is treated as ECI, and Rev. Rul. 91-32 has been controversial since its issuance. The Grecian Magnesite case was the first time a court has addressed the IRS’s controversial position in Rev. Rul. 91-32.
Grecian Magnesite Decision
Grecian Magnesite, Mining, Industrial and Shipping S.A. (“GMMIS”) is a Greek corporation in the business of extracting, producing, and selling magnesia and magnesite worldwide. GMMIS owned a membership interest of more than 10% in Premier Magnesia, LLC (“Premier”), a Delaware LLC that is in the business of extracting, producing, and distributing magnesite from mines in the US and treated as a partnership for US federal tax purposes. Since Premier owned several mines and other property in the US, its foreign partner, GMMIS, was treated as engaged in a US trade or business under IRC Section 875(1) and was allocated a distributive share of ECI. Other than its ownership interest in Premier, GMMIS had no office, employees, or other business operations in the US.
When GMMIS’s partnership interest in Premier was redeemed in 2008 and 2009, GMMIS realized a total gain of $6.2 million. No tax attributable to the US real estate appreciation was withheld by Premier and none was paid by GMMIS with its final tax return filings in 2008 and 2009. The IRS claimed that the entire redemption resulted in taxable capital gain since the entire gain constituted ECI under Rev. Rul. 91-32. GMMIS conceded that $2.2 million of the gain was attributable to the sale of US real property interests pursuant to IRC section 897(g) and thus was taxable, but disputed that the remaining $4 million was taxable ECI.
The question before the Tax Court was whether the $4 million gain GMMIS realized was ECI, specifically (1) whether GMMIS’s sale or redemption of the partnership interest could be tied to the partnership’s US office where Premier conducted its US trade or business under the ECI regulations and (2) whether such US office was a material factor in the production of GMMIS’s gain. Declining to defer to Rev. Rul. 91-32, the court followed the IRC and the regulations to determine whether the disputed gain was ECI.
Under the default sourcing rules for gain realized on the sale of personal property under IRC Section 865(a), a nonresident’s income from the sale of personal property is generally treated as foreign source unless an exception applies. The IRS argued that the “US office rule” exception applied, that if a nonresident maintains a US fixed place of business, then the gain attributable to such office is US source. After attributing Premier’s US office to GMMIS under IRC Section 875(1), the court determined whether the gain was attributable to such office by applying IRC Sections 865(e)(3) and 864(c)(5) which provides that (i) income, gain, or loss is attributable to a US office only if the US office is a material factor in the production of such income, gain, or loss, and (ii) the US office regularly carries on activities of the type from which such income, gain, or loss is derived.
On the first question of whether the US office was a material factor of the gain, the court concluded that Premier’s office was not a material factor in the production of GMMIS’s gain because Premier’s office (i.e., mines) was not material to the redemption transaction itself. By dismissing the IRS’s argument that the sale of the partnership interest was equivalent to a sale of the partnership’s underlying assets, the court considered a partnership interest as a unitary asset, not a share of aggregate partnership assets. On the second question of whether the gain was realized in the ordinary course of the trade or business carried on by the US office, the court concluded that Premier was in the business of producing and selling magnesite and not in the business of redeeming its own partnership interests.
Therefore, the Tax Court held that since GMMIS’s gain on the redemption was not attributable to a US office, it was not ECI and therefore is not subject to US tax.
Private Equity Funds after Grecian Magnesite
Before the Grecian Magnesite decision and in the face of Rev. Rul. 91-32, to protect foreign investors from being attributed ECI and incurring branch profits tax, private equity funds that were treated as partnerships structured the foreign investment through a US blocker corporation. The foreign investors would invest in the blocker corporation which would then invest in the funds and when the foreign investors decided to pull out the investment, they would sell their stock in the blocker corporation rather than having the blocker corporation sell its interest in the funds. Having the US blockers, however, means that the funds have to file US tax returns, which is an additional cost to the funds.
After Grecian Magnesite, if the partnerships in which the funds invest do not hold significant amount of US real property assets and thus not subject to FIRPTA rules, it might be more efficient for the foreign investors to invest directly in the funds without a blocker, especially if the returns from the investment are expected to be primarily in the form of gain from a sale or redemption of the partnership interest rather than in the form of operating profits (which will still be ECI subject to US income tax and potentially branch profits tax). The direct investment in the US partnership by the foreign investors in such a case would be beneficial to the funds since they no longer have to use a US blocker and file US tax returns.
However, such investment without a blocker may be risky because the private equity funds or hedge funds themselves cannot make the same claim as GMMIS. The funds will likely have US offices and buying and selling ownership interests in US partnerships will be in their ordinary course of business. Also, Grecian Magnesite involved the redemption of a minority partnership interest in a continuing partnership, not the sale of substantially all of the partnership’s assets or the sale of the entire partnership interest, which, if done by private equity funds, would be taxable to the foreign partners. Therefore, though the funds might want to eliminate the US blockers, they should be careful in doing so until they see whether Grecian Magnesite is appealed or IRS promulgates contrary regulations.
The private equity fund may draft a partnership agreement to run operating profits from a portfolio business through the partnership to the blocker in which US investors invest but allocate capital gains on the portfolio business assets directly to the foreign investors without running them through the blocker. However, the safer investment route is to use the blockers. In a hypothetical investment situation, a private equity fund organized in a tax haven with no US tax treaty would own interests in one or more US portfolio companies, run the portfolio companies for a few years and then sell them. US investors would invest in the fund directly, and foreign investors would invest in the fund through common shares in a US blocker corporation that owns interest in the fund.
The blocker then would hold different kinds of interest in the target partnership to be acquired and sold by the fund. The blocker would own a profits interest in the target partnership, entitling the blocker to the target’s operating income. The blocker would also issue a warrant to the foreign investors for its profits interest, effectively capping the taxable income that would run through the blocker. The foreign investors would separately hold a direct capital interest in the target, entitling them to the proceeds from the sale of the target’s assets. When the target is ready to sell its portfolio business, the foreign investors would sell their partnership interests to a buyer, resulting in return of capital and capital gain. They would sell their warrant to the buyer who would then exercise it to receive or sell the profits interest. In the end, through the blocker, the foreign investors would pay US tax on current operating income. The foreign investors can sell the warrant separately, or exercise it and sell the profits interest, and the gain on such sale would not be subject to US tax unless hot assets are involved. When the target is sold, the gain on the sale of the capital interest would also not be taxable in the US to the foreign investors.
As long as the two types of partnership interests are properly priced and separate interests are respected, Grecian Magnesite enables the foreign investors to avoid tax on non-ECI capital gain. However, the investors must still be aware of the partnership rules where such structure may be under attack via other means (e.g., economic substance, business purpose, etc.).
Although the Grecian Magnesite decision may sound very favorable to foreign investors investing in US partnerships, the court’s holding should not be understood to extend to other situations because of the limited factual record the Court had before it. The foreign partners should be mindful of the fact that the gain attributable to the US real estate appreciation is taxable under the FIRPTA rules, which override ECI rules used by the Tax Court in deciding Grecian Magnesite. There is also a possibility that the IRS will issue regulations that will not follow Grecian Magnesite. Additionally, US-managed private equity funds that are in the business of buying and selling ownership interests in the US cannot rely on Grecian Magnesite and therefore should use US blockers to protect the foreign investors.« End the Year on a High Note with Up-To-Date Trust-Based Estate Planning