Posted by John Cohn, Todd Keator, and Kathleen Gerber In a recent case, Grecian Magnesite Mining, Industrial & Shipping Co., S.A., v. Commissioner, 149 T.C. No. 3 (July 13, 2017), the Tax Court declined to apply the principles of Rev. Rul. 91-32 when determining whether gain realized by a foreign partner upon the redemption of its interest in a U.S. partnership was effectively connected income with a U.S. trade or business (“ECI”) and, thus, subject to U.S. taxation. Code Section 741 provides that gain from the sale or exchange of a partnership interest generally results in capital gain. However, any portion of the gain that is attributable to inventory or unrealized receivables of the partnership (“Hot Assets”) is treated as ordinary income under Code Section 751. U.S. source capital gains realized by a foreign person generally are not subject to U.S. taxation unless they are ECI. Under Code Section 897, enacted under the Foreign Investment in Real Property Act (“FIRPTA”), U.S. source capital gains attributable to U.S. real property interests (“USRPIs”) are treated as ECI and, thus, are subject to U.S. taxation. When a foreign partner disposes of an interest in a partnership that owns USRPIs, FIRPTA applies a look-through rule such that any portion of the gain attributable to the partnership’s USRPIs is treated as ECI. Thus, the rules of Code Section 751 with respect to Hot Assets and Code Section 897(g) with respect to USRPIs apply an “aggregate theory” rather than an “entity theory” to determine the character and source of the gain realized upon a disposition of a partnership interest. Under the source rules, Code Section 865(a) generally provides that income from sales of personal property are sourced based on the seller’s residency. Code Section 865(e) provides an exception to this rule pursuant to which income from sales of personal property that are attributable to an office or other fixed place of business in the United States is treated as U.S. source. Further, under Code Section 864(c), U.S. source gain from the sale or exchange of a capital asset that is ECI property is treated as ECI. The IRS position, as articulated in Rev. Rul. 91-32, is that when a foreign partner sells an interest in a partnership engaged in a U.S. trade or business, for purposes of applying these rules and determining the source and ECI character of the income, it is appropriate to treat a foreign partner’s disposition of its interest as a disposition of an aggregate interest in the partnership’s underlying property.Background. The taxpayer in the Grecian Magnesite Mining, Industrial & Shipping Co., S.A., v. Commissioner was a foreign corporation that had no offices, employees or business operations in the United States other than through its ownership interest in a Delaware LLC taxed as a partnership. The partnership was engaged in the business of extracting, producing, and distributing magnesite in the United States. The taxpayer realized gain in both the 2008 and 2009 tax years as a result of the partnership’s redemption of its partnership interest. The taxpayer did not report any of the gain that it realized as a result of the redemption on its U.S. federal income tax return for 2008 and did not file a U.S. federal income tax return for 2009. The IRS determined that the taxpayer was subject to U.S. taxation on the full amount of the gain and issued a notice of deficiency. The taxpayer conceded that the portion of the gain that was attributable to the partnership’s USRPIs was subject to U.S. taxation under Code Section 897(g), but disputed the IRS’s determination that the remainder of the gain was also subject to U.S. taxation as ECI.Decision. The Tax Court declined to apply the principles of Rev. Rul. 91-32 and held that the portion of the gain that was not attributable to the partnership’s USRPIs was capital gain that was not subject to U.S. taxation. The Tax Court noted that a two prong test must be met for gains to be treated as attributable to a U.S. office and, thus, treated as ECI under Code Section 865(e): (i) the U.S. office must be a material factor in the production of the disputed gain; and (ii) the disputed gain must be realized in the ordinary course of the U.S. business. The Tax Court rejected the Commissioner’s argument that the test should be applied to a hypothetical sale of the partnership’s assets, stating that the Commissioner’s argument missed the mark. The Tax Court noted that if the Commissioner’s view was correct it would yield an “aggregate theory” general rule that would render “superfluous” the aggregate theory rules of Code Section 751 with respect to Hot Assets and Code Section 897(g) with respect to USRPIs. Both of these provisions presume an “entity theory” general rule for purposes of determining the character of the taxable gain realized upon a disposition of a partnership interest, to which the Section 751 and Section 897(g) “aggregate theory” rules are exceptions. Accordingly, the Tax Court applied the test to the actual redemption transaction, and determined that neither prong was met.Implications. The IRS has not yet filed an appeal, or indicated if it intends to do so. If an appeal is filed, it likely would be filed in the Tenth Circuit. If the decision is not appealed or is sustained on appeal, the effect of the case will be significant for foreign partners in partnerships engaged in a U.S. trade or business. For example, some foreign partners that otherwise may have structured ownership of a U.S. partnership interest (generating ECI) through a U.S. blocker corporation may instead decide to forego use of the blocker where the exit may be structured as a sale of the partnership interest, as opposed to a sale of the underlying assets. Although earnings allocable to the foreign partner during the operations years may be ECI under this structure, under Grecian Magnesite, assuming there are no underlying USRPIs, the gain on exit may escape U.S. taxation entirely. Rev. Rul. 91-32 has long been criticized by practitioners as overreaching. The Green Book for fiscal year 2013 (i.e., the publication released by the Treasury Department each year to explain the Presidential Administration’s revenue proposals for the coming fiscal year) included a proposal to codify the IRS position articulated in Rev. Rul. 91-32 and impose a 10% withholding requirement on purchasers of partnership interests (similar to the withholding requirement imposed under FIRPTA, which was increased to 15% under the recent PATH Act of 2015) unless the seller provides a certification that it is not a foreign person or a withholding certificate from the IRS indicating that no or a reduced rate of withholding is required. The proposal has appeared in each subsequent Green Book through fiscal year 2017. The Trump Administration has not yet included codification of Rev. Rul. 91-32 in its publicly available revenue proposals.If you have any questions about the implications of this recent case or other ECI issues, please contact one of us or any of the other Tax lawyers at Thompson & Knight.  Dept. of the Treasury, General Explanations of the Administration’s Fiscal Year 2013 Revenue Proposals.