On 11 June 2019, the US Court of Appeals for the D.C. Circuit in Grecian Magnesite Mining, Industrial & Shipping Co., SA v. Commissioner, 123 AFTR 2d 2019-2164 (D.C. Cir. 11 June 2019) affirmed the Tax Court’s conclusion that a foreign partner is not generally taxable on the gain recognized upon redemption of its membership interest in a domestic partnership doing business in the United States (See Grecian Magnesite Mining, Industrial & Shipping Co., SA v. Commissioner 149 T.C. No. 3 (2017)), with the one exception being the portion of the gain recognized that is attributable to US real property owned by the partnership.
As background, the case concerned the proper treatment of the gain recognized upon redemption of a foreign partner’s membership interest in a US partnership. Grecian Magnesite Mining (GMM) was a Greek corporation that had no office, employees, or business operation in the United States. Since 2001, GMM was a partner in a Delaware limited liability company (Premier), which was treated as a partnership for US federal income tax purposes. In 2008, GMM entered into an agreement for Premier to redeem GMM’s interest in Premier for $10.6 million, realizing gain of $6.2 million. Of the total gain realized, $2.2 million was attributable to Premier’s US real estate, and conceded as taxable under FIRPTA. The remaining $4 million was the amount in dispute.
In the Tax Court, the Commissioner raised two principal arguments: (1) the disposition of a partnership interest should be treated like a sale of the partner’s distributive share of each of the partnership’s underlying assets under the “aggregate theory” of partnerships (wherein partners are viewed as directly owning the partnership’s assets); and (2) the disputed gain was attributable to GMM’s US office (attributed through Premier) under the US office rule (as defined below), and therefore US source income, because all activities leading to the appreciation of the partnership share occurred in the United States through Premier’s successful operations.
The Tax Court sided with GMM on both arguments, holding that: (1) GMM’s interest in the partnership was a single, indivisible capital assets (i.e., the “entity theory” of partnerships); and (2) the income from the redemption was not attributable to the US office under the US office rule because the US office neither was a material factor in the redemption transaction nor regularly carried on activities of that type.
Appeals Court’s Analysis
Since the Commissioner did not challenge the Tax Court’s first holding on appeal (i.e., the “aggregate” versus “entity” theory of partnerships), the only question for the court to address on appeal is whether the disputed gain is attributable to a US office of GMM and as such, is sourced within the US (the “US office rule”). Under the US office rule, “if a nonresident maintains an office or other fixed place of business in the US, income from any sale of personal property (including inventory property) attributable to such office or other fixed place of business shall be sourced to the US.” There are three prongs to the US office rule: (1) whether GMM has a US office or fixed place of business; (2) whether GMM’s US office is a material factor in the production of such income, gain or loss; and (3) whether GMM’s US office regularly carries on activities of the type from which such income, gain or loss is derived. All three prongs must be met in order for the income to be treated as US sourced. The court focused its analysis on the text, Treasury Regulations and legislative history of the US office rule, specifically as it relates to the third prong.
The Commissioner argued that the statutory language “attributable to such office or other fixed place of business shall be sourced to the US” modified the noun “income” and therefore the activity that generated the appreciation in Premier’s value (i.e., the profitable operation of its magnesite mining business) is attributable to the US office. Whereas GMM applied the rule of last antecedent, which interprets a limiting phrase to modify the noun that it immediately follows, and argued that the language modified the noun “sale” and as a result the transaction itself (i.e., the redemption) should be attributable to the US office. The court agreed with GMM’s interpretation of the statute and held that in general qualifying phrases attach to the terms that are nearest and in this case, the noun “sale” is modified.
To further support its decision that the rule was framed to apply to sales, opposed to income, the court analyzed the statute and corresponding Regulations as whole. Specifically, the court addressed the reference to section 864(c)(5), which provides that “income, gain or loss shall not be considered as attributable to an office or other fixed place of business within the US unless such office or fixed place of business is a material factor in the production of such income, gain or loss and such office or fixed place of business regularly carries on activities of the type from which such income, gain or loss is derived.” The court held that the better approach is to read section 864(c)(5) at a “higher level of generality” and rejected the Commissioner’s position that Premier regularly carried on redemption activities as a result of engaging in the business of managing transactions with its members. The court found that Premier was in the magnesite mining business and, as such, the redemption transaction was not within its ordinary course of its business.
Finally, the court reviewed the legislative history of the US office rule. Congress enacted the US office rule in response to an exception to the general rule that income is sourced according to a taxpayer’s residence. The US office rule sought to address a situation in which a foreign resident engages in business operations through a US office or fixed place of business and avoids paying US tax on the income because its income is sourced to a foreign jurisdiction. The US office rule sourced income from sales occurring in US offices or fixed places of business according to the location of the activity giving rise to the sale, as opposed to the taxpayer’s jurisdiction of residence. The court highlighted that the emphasis was on sales activities attributable to a US office or fixed place of business.
The court found that the US office rule was not satisfied because the third prong of the rule was not met, as Premier was not engaged in the business of partnership redemption but rather was in the business of magnesite mining. As a result, the disputed gain derived from the redemption was not US sourced.
The court’s holding in Grecian Magnesite is a hollow victory for taxpayers, insofar as the Tax Cuts and Jobs Act (TCJA) added section 864(c)(8) to provide that a foreign partner’s gain or loss from the sale or exchange of an interest in a partnership is treated as effectively connected with the conduct of a trade or business in the United States to the extent that the partner would have had effectively connected income had the partnership sold all of its assets at fair market value on the date of disposition. In enacting section 864(c)(8) Congress adopted a modified version of the "aggregate theory" approach to partnership taxation, according to which partners are viewed as directly owning the partnership assets (which contrasts with the "entity theory" whereby a partner’s interest in a partnership is treated as a capital asset). Section 864(c)(8) applies to sales, exchanges, or other dispositions occurring on or after 27 November 2017. To the extent the disposition of a partnership interest occurred prior to that date, the holding in Grecian Magnesite remains authoritative.
TCJA also includes a new section 1446(f) which requires a transferee to withhold 10% of the amount realized on the sale or exchange of a partnership interest by a non-US person if any portion of the seller’s gain on the disposition would be effectively connected income under section 864(c). On May 7, 2019, the IRS released proposed regulations expanding on the transferee’s withholding obligations and addressing potential exceptions under section 1446(f). See prior Tax News and Developments article, “Proposed Regulations for Foreign Partner Effectively Connected Income and Withholding” (June 2019).