This Cadesky U.S. Tax Tip is the third of three that deal with non-residents investing in the United States via partnerships or limited liability companies (LLCs). Part 1 looked at the U.S. implications of the partnership or LLC not timely filing a U.S. partnership return nor timely filing Schedule K-1 (Form 1065), “Partner’s Share of Income, Deductions, Credits, etc.” Part 2 looked at the withholding obligations the partnership has with respect to distributions to non-resident partners. In part 3 we will look at how the U.S. treats the sale or redemption of a non-resident partner’s partnership interest.
In general, under IRC §865(a)(2), when a non-resident sold shares of a U.S. corporation (which are considered as personal property), the gain was sourced “outside the United States”. As such, the U.S. did not tax the gain. There are exceptions, however, where the underlying value is attributable to U.S. real property. In the case of a sale of redemption of a U.S. partnership interest (whose value was not related to U.S. real property), the case was not clear.
The question was whether to apply an “aggregate” or an “entity” approach. Under the “aggregate” approach a partnership is considered as an aggregate of individual co-owners who have bound themselves together with the intent to share gains and losses. Under this approach the partnership has no existence separate and apart from its partners. As such, each partner is viewed as directly owning an undivided interest in the partnerships’ assets and operations.
Under the “entity” approach a partnership is treated as a separate and distinct entity to which each partner has a piece of ownership. In this aspect a partnership interest in similar to a share of a corporation. The partnership interest would be an intangible personal property.
The IRS had issued Rev. Rul. 91-32, 1991-1 C.B. 107 where they applied the aggregate approach to a non-resident’s disposition of a United States partnership interest. Rev. Rul. 91-32 reflects the IRS position that a non-U.S. investor selling an interest in a partnership will, for U.S. federal tax purposes, be treated as realizing income that is effectively connected with a U.S. trade or business (ECI) to the extent the gain on the sale of the interest is attributable to a U.S. trade or business of the partnership operated through a fixed place of business. In that situation, rather than characterizing gain from the sale of the partnership interest as non-US-source gain from the sale of property (which is generally not subject to US federal income tax), the 1991 ruling treats the non-US investor’s gain on a sale of the partnership interest as ECI to the extent attributable to the partnership’s assets that would generate ECI if sold by the partnership. Accordingly, the ruling characterizes any such gain as ECI to the extent such gain is attributable to the non-US investor’s share of the partnership’s property used to generate ECI.
Many in the tax community, however, strongly disagreed with the IRS as they felt that the IRS position had no basis in law.
The matter was not resolved until July 13th, 2017 when the United States Tax Court heard the case of Grecian Magnesite Mining, Industrial & Shipping Co., S.A. v. Commissioner of Internal Revenue (149 T.C. No. 3). The Court held that a non-US partner is not subject to U.S. tax on gain arising from the sale of a partnership interest which conducts business in the United States. It applied the entity approach and rejected the aggregate theory espoused in IRS Rev. Rul. 91-32. The IRS appealed and lost.
What happens when a taxing authority loses a court case? The government changes the law. The 2017 Tax Cuts and Jobs Act repealed the result in the Grecian Magnesite decision and codified Rev. Rul. 91-32 into law.
What’s the law now?
Two new code sections were introduced, IRC §864(c) and IRC §1446(f) which are effective for dispositions occurring on or after November 27, 2017.
Under IRC §864(c), a foreign partner’s disposition of a partnership interest is subject to U.S. taxation as effectively connected income (ECI) to the extent that the foreign partner would have had ECI had the partnership hypothetically sold all of its assets at fair market value on the date of disposition.
IRC §1146(f) imposes a withholding obligation, on the buyer, equal to 10% of the amount realized by the (non-resident) seller if any portion of the seller’s gain would be ECI under these new rules. This is not a final tax, the seller will receive credit any amounts withheld when they file their U.S. non-resident income tax return.
The take-away
Non-residents who sell or redeem a partnership interest may now be subject to U.S. federal taxation to the extent that a portion (or all) of the gain is considered to be ECI. Much of the information required to make these determinations has to come from the partnership itself and extra work will be required to accurately perform the necessary computations.
The gain, though ECI, will still be considered a capital gain and, depending on the holding period, may qualify as a long-term capital gain. The maximum U.S. federal tax rate on a long-term capital gain is 20% (for individuals and trust). State taxes may also arise.
The U.S. tax may, however, be eligible as a foreign tax credit in the non-resident’s country of residence. If a full FTC is granted in the country of residence then the taxpayer is, globally, no worse off paying the U.S. tax as his overall global tax will not have changed. As such, when looking at investing in the U.S. via a partnership it is imperative that the taxpayer’s global tax position be reviewed, not just the fact that there is now a U.S. tax liability.
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