Podcast: Grecian Magnesite Mining v Commissioner of Internal Revenue
Isabelle Farrar, a senior associate in the Tax Controversy Group discusses one of the most notable decisions of third quarter 2017, Grecian Magnesite Mining v Commissioner of Internal Revenue, with Rom Watson, a partner in the Tax Group and co-head of the firm’s International practice group. Grecian Magnesite Mining considered whether a foreign corporation’s proceeds arising from the redemption of an interest in a U.S.-based partnership were taxable in the U.S. as U.S.-source income or income effectively connected with a U.S. trade or business (ECI). In doing so, the Tax Court called into question the validity a 30-year old revenue ruling.
Isabelle Farrar: Hello, and thank you for joining us today on this Ropes and Gray podcast. I'm Isabelle Farrar, a senior associate in the tax controversy group. Joining me today is Rom Watson, a partner in the tax group who specializes in international tax issues and serves as the co-head of the firm's international practice group. In today's podcast, we are going to discuss a notable Tax Court decision, which we've chosen as our case of the quarter. This case, Grecian Magnesite Mining v. Commissioner of Internal Revenue, dealt with the tax treatment of a foreign corporation's proceeds arising from the redemption of an interest in a U.S.-based partnership. Specifically, the case considered whether those proceeds were taxable in the U.S. as U.S. source income or income effectively connected with a U.S. trade or business, which is often referred to as ECI. The IRS and the taxpayer agreed that a certain portion of the proceeds were attributable to the sale of U.S. real property and were thus taxable under Code section 897(g). But the remainder of the proceeds were at issue. As we will see, this was a particularly notable decision because it did not follow Revenue Ruling 91-32, a somewhat controversial ruling issued by the IRS, but which was generally regarded as the main authority in this area.
Rom, I understand that the petitioner, Grecian Magnesite Mining or GMM was a privately owned Greek corporation that focused on magnesite mining and sales all over the world and also owned a minority interest in a U.S. partnership. Could you tell us more about it?
Rom Watson: Sure. As you said, GMM was a Greek corporation, and it operated a worldwide business of mining and selling magnesia and magnesite to customers around the world. GMM's principal place of business was in Athens, Greece. It had no office, no employees, and no business operations of its own in the United States. Its only business connection with the United States was a fairly small interest in a U.S. LLC called Premier Magnesia. We'll refer to it today as Premier. G.M.M’s ownership percentage of the LLC varied from 12% to 15%. Premier was organized in 2001, and like many LLC's it was classified as a partnership for U.S. income tax purposes. It operated a mining and distribution business for magnesite within the United States. Throughout its ownership period from 2001 to 2008, the Greek partner reported and paid U.S. tax on its share of Premier's taxable income. However, in 2008, GMM decided to get out, and it redeemed its full interest in Premier for $10.6 million. As a result of this redemption, GMM realized a $6.2 million gain. And as you mentioned, some portion of it, actually $2.2 million, was attributable to appreciation of U.S. real estate assets held by Premier. But the remaining $4 million of gain was attributable to appreciation in Premier's U.S. magnesite business itself. The IRS audited this transaction and looked carefully at the redemption. As you described, the parties agreed that the portion of the gain attributable to U.S. real estate was taxable under specific Internal Revenue Code provisions that ensure foreign investors pay tax on gain they realize from U.S. real property. But GMM argued that the remaining portion of the gain, the $4 million of gain that was not related to real estate, was attributable to its partnership interest itself and was not subject to tax. The IRS, on the other hand, argued that the $4 million of gain was effectively connected income with a U.S. trade or business (or ECI) and therefore fully taxable. This difference of opinion on the tax treatment of the redemption was the issue analyzed by the Tax Court in July.
Isabelle Farrar: So if GMM had to pay tax on its share of Premier's earnings during all the years that it owned an interest in Premier, why wouldn't it also have to pay tax when it redeemed its interest in Premier?
Rom Watson: That was the central question of the case. To analyze it, you have to consider the interplay between the U.S. tax rules that govern partnership taxation and the tax rules that apply to foreign persons who have contacts with U.S. markets – two completely separate regimes. Generally, if a foreign individual or company realizes a capital gain on an investment asset, then that gain is exempt from U.S. income tax. As mentioned earlier, the U.S. rules do tax a non-U.S. person's gain attributable to U.S. real estate. But if the non-U.S. person realizes a capital gain from most forms of personal property, then that gain is generally exempt from U.S. tax. The classic example is a non-U.S. investor trading on U.S. stock exchanges that realizes a gain from selling shares-- even if the shares are issued by U.S. companies, generally there is no U.S. tax imposed on that capital gain under general U.S. tax principles. Turning to the partnership regime, additional rules come into play to account for the fact that a partnership, unlike a corporation, is not taxed at all at the entity level. Rather, the tax obligations that arise from a partnership's business operations generally pass through to the partners, and are characterized in the partners’ hands as if the partners had realized the income directly. This is why GMM did pay U.S. income tax during its ownership period of Premier. Even though its operations were in Greece and it was completely outside of the United States, each year from 2001 to 2008, GMM received a Schedule K-1 form from Premier showing GMM's share of the LLC's taxable income. Since that income was derived from business operations in the U.S., GMM was treated just as if it had conducted those operations directly, and had earned a pro rata share of effectively connected income from a U.S. trade or business. The U.S. tax laws are clear that such business income (or ECI) is fully taxable when earned by non-U.S. partners like GMM, even if they are merely passive investors and have nothing to do with the operations or the management of the partnership. The Internal Revenue Code supports this conclusion clearly in section 875, which provides that if a foreign person is a partner of a partnership, and the partnership is engaged in a U.S. trade or business, then the foreign person will be considered as being engaged in the U.S. trade or business as well. Those rules ensure that partnerships can't escape U.S. taxation on their domestic business operations, even if they are owned by non-U.S. partners.
So turning to the current case, the Tax Court had to determine how these two paradigms interact in the case of a redemption of a partnership interest. The $4 million of gain realized by the Greek corporate partner was not an allocation of the LLC's separate business income on Schedule K-1. Rather, it was the outside gain realized by GMM from its sale of a partnership investment itself. Should that gain be exempt like other capital gains realized on sales of personal property? Or should it be classified as if GMM had actually sold its share of the U.S. magnesite business assets and was thus taxable on its pro rata share of such income as ECI?
Isabelle Farrar: I understand that, in the case, the IRS and the taxpayer each took different positions as to whether the sale of GMM's partnership interest should be taxed on the basis of the “aggregate approach” or the “entity approach.” Could you describe what that means?
Rom Watson: Sure, that's one way of looking at the two different approaches that apply here. Actually partnership tax rules can apply either an aggregate or an entity approach depending on the context. On the one hand, partnerships are considered distinct legal entities, and they report their separately computed taxable income on an annual tax return. So a partnership is treated like a separate entity for that reason. On the other hand, the tax is not paid by the partnership itself, but flows through to each of the partners. In short, the partnership is sometimes treated as an entity for tax purposes, but in other contexts, the partnership is viewed as merely an aggregation of the partners, who are each subject to tax on the partnership operations based on their ownership percentage of those operations. When an aggregate approach applies, the partners are treated as if they each separately held their pro rata slice of partnership assets and liabilities and earned directly a pro rata portion of the business income. The issue faced by GMM and the IRS was, which of these approaches is the correct treatment when a partner exits a partnership, either by selling its partnership interest to a third party, or, as was the case here, by redeeming that interest and selling it back to the partnership itself? The question of which paradigm should apply to such an exit -- the entity approach or the aggregate approach -- was the central question that the Tax Court faced in this case.
Isabelle Farrar: What approach does Revenue Ruling 91-32 take in that regard?
Rom Watson: Revenue Ruling 91-32 was important to the analysis in this case, because in 1991, the IRS had considered this very question on how an exit from a partnership by a foreign partner should be classified for U.S. tax purposes. In that ruling, the IRS clearly adopted an aggregate approach to this issue. Revenue Ruling 91-32 held that when a foreign partner sells an interest in the partnership, the tax on the sale of that interest should be analyzed on an asset-by-asset basis, just as if the foreign partner had owned and sold a pro rata share of each of the assets in the partnership. This is similar to the rules applicable to real estate assets, which look through the partnership and tax each partner separately on a pro rata share of any gain attributable to real estate. Similarly, according to the ruling, to the extent a foreign partner realizes gain on an exit from a partnership, and to the extent the gain is attributable to assets used in the partnership's U.S. business operations, then that portion of the overall gain should be classified as ECI and fully subject to U.S. tax.
In fairness, the IRS did have strong policy reasons for reaching this result. After all, if the partnership itself had actually sold its own U.S. business assets for a gain, then the foreign partners would have clearly been subject to U.S. tax on their share of that business gain. It would have been allocated to them on a Schedule K-1, and they would have each paid U.S. tax on their pro rata share of the gain. Moreover, if GMM in this case, instead of being a 15% partner, had held 100% of Premier, then regardless of whether it had sold the LLC interests or redeemed them, or if the LLC had sold the underlying assets, in each case all of the gain attributable to the ECI assets would have been fully taxable in the hands of GMM. So the ruling follows the policy position that there should be a consistent approach when a 15% partner exits from a U.S. business conducted through a partnership and it realizes gain from the appreciation on 15% of the U.S. business.
In any case, at least for the last 26 years, the IRS has followed the approach stated in Revenue Ruling 91-32 -- it has consistently asserted tax on non-U.S. partners whenever they sell or redeem their partnership interests to the extent that they have gain on those interests attributable to U.S. business operations of the partnership. Nevertheless, many commentators have questioned the result of this revenue ruling, arguing that in spite of the underlying policy reasons for reaching this conclusion, the IRS position is not supported by the Code or applicable regulations, and that the IRS was overreaching when it asserted this conclusion.
Isabelle Farrar: How is the Tax Court’s approach different from the revenue ruling?
Rom Watson: Unlike the reasoning in Revenue Ruling 91-32, the Tax Court did a comprehensive analysis of the statutory and regulatory language involved in these two areas of law -- investment income for non-U.S. persons and partnership taxation. It noted that the Code provides a general rule that gain realized by an exiting partner from a partnership is classified as gain from a single capital asset, the partnership interest itself. In the view of the Tax Court, the Code itself applies an entity approach to this issue. In specific instances, such as where the partnership owns U.S. real estate, then the Code does have very specific exceptions that require a foreign partner to look through the partnership interest to the underlying assets for characterizing the partner's portion of real estate gain. But without a specific support in a Code provision, and with no support in regulations, the foreign partners should benefit from the normal rule for other investment property when they sell their partnership interest. As discussed previously, gains from capital assets realized by non-U.S. persons are generally exempt from U.S. tax. And that was the conclusion the Tax Court ultimately reached here with respect to GMM's redemption of its interest in Premier.
But the court reached this conclusion only after examining quite closely the applicable Code provisions. It specifically looked at Code section 731(a), which deals with the tax classification of distributions to partners (such as the redemption payments made by the LLC to G.M.M). Code section 731(a) states, “Any gain or loss recognized under this subsection shall be considered as gain or loss from the sale or exchange of the partnership interest of the distributee partner.” That is, the redeeming partner in such cases is not treated as having sold its portion of the partnership's assets, but rather it's treated as selling a single asset, the partnership interest itself.
Isabelle Farrar: A large portion of the Tax Court decision is devoted to the source rules of the Code. How do those principles affect the outcome of the case?
Rom Watson: The Tax Court did apply the source rules of the Code to support its holding. As we've discussed previously, a non-U.S. person generally is subject to U.S. income tax on non-investment income only when it constitutes effectively connected income with a U.S. trade or business or ECI. The Code rules that determine whether capital gains should be classified as ECI apply several tests to distinguish investment-related capital gains from business-related ECI. In particular, for capital gains realized from the sale of non-inventory personal property, like the type of property involved with Premier's U.S. business, the gain initially has to be classified as U.S. source gain before it can be tested further to determine whether it is ECI. The general source rule for capital gain from sales of personal property starts with Code section 865, which provides that capital gains realized by non-U.S. persons from sales of personal property are not from U.S. sources. That is, the rules basically look to the residence of the seller, and if the seller is a non-U.S. person, the rules characterize the gain as foreign source income. If that general rule is applied to the facts here, GMM is a Greek corporation with no separate operations within the U.S., and the gain it realized from the sale of its partnership interest in Premier would be foreign source gain. Therefore, the capital gain would fall outside of the definition of ECI and would not be subject to U.S. tax.
Isabelle Farrar: But in the Tax Court decision, the court focused on one of the exceptions to that general source rule.
Rom Watson: That’s correct -- the IRS did not let the taxpayer off the hook that easily. There is an exception to the general rule in section 865(e)(2). That exception applies in cases where a non-U.S. person maintains an office or a fixed place of business in the United States and realizes gains from sales of personal property, where the gains are attributable to that office. For example, where a foreign owner sells non-inventory goods from a U.S. office, but those gains are attributable to that office under the regulatory tests, then the capital gains are no longer exempt from tax under the general foreign source rule for personal property sales. If this U.S. office exception applied here, the gains would be classified as U.S. source income, and would likely meet the other tests to be treated as taxable ECI.
That was the exception relied on by the IRS in both Revenue Ruling 91-32 and in the Tax Court case. The IRS used that exception to support its view that a non-U.S. partner exiting a partnership should be subject to tax. Initially, the IRS reasoned that when a partnership operates through a U.S. office or fixed place of business, then that place of business should be attributed to each of the non-U.S. partners. In the present case, the Greek corporation had no U.S. office of its own, but the IRS argued that, it was the office of Premier that should be attributed to the non-U.S. partners, like the Greek corporation. Moreover, in the next more controversial step of reasoning, Revenue Ruling 91-32 also concluded that any gain realized by a non-U.S. partner on an exit from a partnership should be attributable to the U.S. office the partner is deemed to have “through” the partnership. As a result, the IRS applied the section 865(e)(2) exception to determine that the gain on the partnership interest constituted the sale of personal property that was attributable to a U.S. office, when that U.S. office was actually the office of the partnership itself. Tax could therefore be imposed even if the non-U.S. partner (like GMM) had no U.S. office of its own.
Isabelle Farrar: That sounds like creative reasoning from the IRS. But I understand that the Tax Court was not impressed.
Rom Watson: Correct. The Tax Court dismissed these logical leaps of Revenue Ruling 91-32 and refused to impute Premier's own U.S. offices to GMM for purposes of applying this U.S. office exception in the source rules of Code section 865(e)(2). The court first observed that GMM had no actual U.S. office in the U.S.; and to the extent that GMM was deemed to operate through the U.S. offices of Premier, then those operations were involved solely in the production and sales of magnesite. Those offices were not involved in sales of partnership interests. Applying the existing regulatory tests for when sales are attributable to an office or fixed place of business, the court emphasized that the exception only covers cases where the office is a material factor in realizing the gain from the sale, and only when that type of gain is from activities that are regularly carried on by the office in the ordinary course of its business.
Those rules make sense when applied to sales of other types of personal property that might generate capital gains. In order to be attributed to a U.S. office, the gain has to be a type of transaction that that office does regularly, and the office must actually be involved in the sale. In contrast, when GMM redeemed its partnership interest, there was very little participation by Premier's own U.S. offices. Premier’s U.S. offices were devoted to selling magnesite, and were not “regularly” engaged in selling partnership interests. As a result, the Tax Court concluded that the redemption was not attributable to the U.S. offices operated by Premier, and therefore the exception from 865(e)(2) did not apply on these facts. As a result, the capital gain remained under the general rule and was classified as “foreign source income.” Furthermore, this “foreign source” gain could not be ECI and therefore was not taxable.
Isabelle Farrar: So under the Tax Court’s rationale, are all foreign partners exempt from U.S. tax on gains realized by the sale of partnership interests?
Rom Watson: The answer to that question is not entirely clear, and depends on how broadly this decision will be applied in the future. The Tax Court certainly struck a strong blow to the conclusion reached in Revenue Ruling 91-32. But the court may not have reached the same result on different facts. For example, if the Greek corporate partner had a greater presence in the U.S. on its own, or if it had been an indirect investor in Premier through a U.S.-based fund of funds, then there would be additional U.S. activities in the chain of ownership, and those additional U.S. activities might have provided a stronger basis for applying the U.S. office exception in the source rules. In short, the facts presented in this case where quite favorable to the taxpayer, and it is not certain that all gains from sales or redemptions of partnership interests involving U.S. business operations will be exempt from tax under the court's analysis in future cases.
Isabelle Farrar: Do you think that the decision will be appealed or that Congress will change any of the statutes or that the IRS will issue new regulations on this topic?
Rom Watson: Those future developments are very possible. Congress may well respond to this case by proposing new legislative changes, which could be revenue raisers as part of tax reform efforts. Separately, the IRS could appeal this case, or they could propose new regulations to change the result. As I mentioned earlier, there are persuasive tax policy reasons for taxing non-U.S. partners who exit partnerships with appreciated U.S. business operations. The current Code is very clear that a non-U.S. person has to pay tax on the gain realized from a direct sale of a U.S. business conducted in a branch form, for example. In that case, the buyer gets a full step-up in the basis of the assets, and therefore the sale may be the government’s last chance to collect U.S. tax on the appreciation. Just in terms of fairness and consistency, it is questionable whether that result should be different if the U.S. business were conducted by multiple foreign owners in partnership form. In addition, tax advisors could apply the Tax Court holding, and insert partnership structures above U.S. business operations owned by non-U.S. people in order to benefit from the conclusion in this case. So for those reasons alone, the government could be under pressure to either seek an appeal or to change the law in this area.
On the other hand, it should be noted that the Tax Court decision is in some ways more workable and easier to implement than Revenue Ruling 91-32. The approach in the revenue ruling requires a foreign partner, even a small minority partner, to obtain detailed information from the U.S. partnership regarding how the partner’s pro rata gain should be attributed to the partnership’s ECI assets. And it's unlikely that such information will be easily obtained in many cases. There is also complexity from the need to net gains and losses from both ECI and non-ECI assets, and difficult questions presented by adjustments between the partner’s outside basis in its partnership interest and the partnership's own inside basis in the ECI assets. So in that regard, the court's holding is a simpler rule, easy to follow, and quite easy to implement. But I believe that we haven't heard the last of this issue. The direction of the future tax law may be unclear at this stage, but it is likely the rules will continue to change in the area.
Based on your experience in tax litigation, what do you recommend to clients today? What are the particular steps that non-U.S. taxpayers should take at this stage just as a result of the Tax Court’s decision?
Isabelle Farrar: I agree that it's currently unclear how the law in this area will evolve. At this point, non-U.S. investors with existing investments who had previously taken a tax position in accordance with Revenue Ruling 91-32 should strongly consider whether they want to file refund claims for open tax years and take a position consistent with the Tax Court decision. In addition, this case teaches a broader lesson about tax disputes and when IRS guidance may be subject to challenge by taxpayers. In the decision, the Tax Court held that the revenue ruling was not simply an interpretation of the IRS's own ambiguous regulations, and therefore it was subject to stricter scrutiny. And the court found that, overall the revenue ruling lacked the power to persuade. In particular, the Tax Court called the revenue ruling's treatment of the partnership provisions “cursory in the extreme” -- which is pretty harsh language for the revenue ruling’s analysis. This case is evidence that courts are willing to take the IRS to task when it issues guidance that, as the Tax Court said, “improperly interprets the text of relevant statutes and has inadequate reasoning.”
Rom Watson: Well, I fully agree with that,. Each regulation must be considered on a case-by-case basis and the pros and cons of litigation considered carefully. But we've seen this pattern before. Whenever the IRS attempts to solve an issue with administrative guidance, and chooses not to follow a more rigorous regulatory path, and particularly where its logic is a stretch under the relevant statutes and regulations, then courts will often look at that guidance very carefully and skeptically. In this case, that judicial review was to the detriment of the IRS's position.
Isabelle Farrar: There is so much more that we could say about this case, but I think we will leave it there for now. Thanks, Rom, for joining me in this fascinating discussion. We will be back next quarter to discuss one of the major tax decisions of the fourth quarter of 2017. Please visit the Tax Controversy Newsletter webpage at www.disputingtax.com, or of course, www.ropesgray.com for additional news and commentary about other notable tax developments as they arise. Thank you for listening.