Tax Reform Complicates Things for Foreign Partners in US Businesses
Like all those subject to the U.S. tax system, foreign partners of U.S. businesses have long had to navigate a difficult set of rules and regulations when the time comes to divest of their ownership. But just when these partners seemed to have been granted some clarity in the landmark 2017 Grecian Magnesite Mining tax court case, new tax reform legislation reversed these hard fought gains and added new layers of complexity.
As part of the Tax Cuts and Jobs Act, Congress passed two significant provisions:
- First, the proportion of any gain attributable to a U.S. trade or business resulting from the direct or indirect sale, exchange, or other disposition of a partnership engaged in a U.S. trade or business, is subject to U.S. taxation. The gain is reduced by any gain from the sale of a U.S. real property interest subject to taxation under the Foreign Investment in Real Property Act of 1980 (FIRPTA).
- Second, the purchaser or other withholding agent of an interest in a partnership engaged in a U.S. trade or business is required to withhold and remit 10 percent of the gross sale price that is attributable to a nonresident alien’s proportional gain or loss of the sale unless: the purchaser receives an affidavit that the seller is a U.S. person; it is determined that no portion of the gain or loss is attributable to a U.S. trade or business; the IRS agrees to a lower withholding amount; or the partnership is publicly traded.
Before we get to the unanswered questions and difficulties these new provisions impose on foreign partners in U.S. partnerships, it’s helpful to review the previous tax treatment and related rulings that brought us to where we are today.
Resolving the debate over tax-triggering “effectively connected income”
The sale or exchange of a partnership interest in a business is generally treated as the sale or exchange of a capital asset, so any gain or loss will also result in a capital gain or loss. Nonresident aliens are only subject to U.S. income tax on capital gains if those gains are treated as U.S. source income “effectively connected” with a U.S. trade or business.
Although there is no strict definition of what constitutes a U.S. trade or business, U.S. courts have defined it as a profit-oriented activity conducted in the United States by a taxpayer (or his or her agents) that is “considerable, continuous, and regular.” This activity must transcend mere ownership of private property. Nonresident aliens owning an interest in a partnership that does business in the United States are considered to be engaged in a U.S. trade or business; this subjects the foreign partner to U.S. taxation on his or her share of allocable income.
In 1991, the IRS released Revenue Ruling 91-32, which concluded that any gain resulting from the sale or exchange of an interest in a partnership with a U.S. trade or business that operated through a U.S. fixed location would result in U.S. effectively connected income (ECI). This was deemed so to the extent of the partner's distributive share of unrealized gain or loss of the partnership that is attributable to property used (or held for use) in the partnership's U.S. trade or business.
To arrive at this conclusion, the IRS applied an “aggregate” theory approach to partnership taxation. First, the IRS reasoned that a foreign partner is treated as engaged in a U.S. trade or business through his or her ownership in a partnership engaged in a U.S. trade or business. It then reasoned that the fixed place of business of the partnership is attributed to the foreign owner. As a result, the IRS took the position that any gain attributable to the U.S. trade or business resulting from the sale or exchange of the partnership would be U.S.-sourced ECI via the partnership’s fixed place of business. This would then subject the foreign partner to U.S. taxation on the sale of the partnership interest.
From the outset, Rev. Rul. 91-32 proved largely ineffective and unenforceable, mainly because, at the time, the U.S. tax code did not contain any provision that expressly states that gains from the sale or exchange of a partnership interest by a nonresident alien individual or foreign corporation is treated as ECI of a U.S. trade or business.
Undeterred, the IRS continued to enforce Rev. Rul. 91-32, which culminated in the landmark 2017 case Grecian Magnesite Mining, Industrial & Shipping Co., SA v. Commissioner (Grecian Magnesite). Contrary to the IRS’s position, the tax court applied the general partnership rule, which is to treat the sale or exchange of partnership interest as a sale of personal property.
The sale of personal property is sourced based on the residence of the seller; therefore, a foreign owner would not be subject to U.S. tax on any gain from the sale or exchange of a partnership interest engaged in a U.S. trade or business. However, if a portion of the gain is attributable to U.S. real estate, the FIRPTA rules apply, subjecting the foreign partner to U.S. tax on that piece of the gain. The purchaser of the partnership interest would be required to withhold 15 percent of the gross purchase price associated with the U.S. real property interest. The tax court’s rejection of Rev. Rul. 91-32 seemed to finally put an end to this long-standing dispute.
Tax reform legislation leaves us with many unanswered questions
Unfortunately, the beneficial Grecian Magnesite ruling was short-lived. As part of the recent passage of tax reform legislation, Congress effectively codified Rev. Rul. 91-32, giving the IRS long desired tax law, and puts those involved in these types of transactions back in the difficult position to comply.
There are several other issues that need to be resolved:
- How to value a partnership’s proportional share of its U.S. trade or business
- How to value assets attributable to a U.S. trade or business
- How the IRS will be able to identify and enforce certain transfers of foreign partnership interests with an active U.S. trade or business
- How the new law will affect current and future income tax treaty negotiations
How we can help
Foreign partners structuring an exit from a U.S. partnership interest should carefully consider how to treat any gain and make sure the new provisions are appropriately applied. CLA’s global tax professionals can help you weigh your options and craft a tax-beneficial strategy.