In a recent case, Grecian Magnesite Mining, Industrial & Shipping Co., SA v. Commissioner of Internal Revenue, the U.S. Tax Court held that a foreign partner’s gain on redemption of a partnership interest was not U.S.-source income and not effectively connected income (ECI), despite the partnership itself being engaged in a U.S. trade or business.
Grecian Magnesite Mining (GMM), a non-U.S. corporation, was a partner in a limited liability company organized and operated in the United States. GMM agreed to have its partnership interest redeemed, but it did not report any of the gain from the redemption on its U.S. income tax return. In response, the IRS issued notices of deficiency for tax due on the full amount of the gain recognized from the redemption of the partnership interest. The taxpayer acknowledged that a portion of the gain was attributable to the sale of U.S. real property interests and should have been subject to tax in the U.S. However, GMM disputed the IRS claim that the remainder of the gain was subject to U.S. income tax.
In reaching its decision, first the court addressed the character of the gain on redemption of the partnership interest. GMM argued that the sale of a partnership interest should be represented as the sale of an indivisible item of intangible personal property rather than as the aggregate sale of separate interests in each partnership-owned asset. The court agreed and concluded any gain from the redemption would be capital gain.
The court then focused on whether or not the capital gain was income effectively connected with the conduct of a trade or business within the U.S. Under a previous IRS ruling, Revenue Ruling 91-32, the IRS held that gain realized by a foreign partner on disposition of a U.S. partnership interest should be analyzed on an asset-by-asset basis. Because partnership gain on the sale of assets used in the conduct of a partnership’s U.S. trade or business is treated as ECI, the ruling concluded that the asset-by-asset analysis of a foreign partner’s gain on the sale of a partnership interest also would cause that gain to be ECI. As the court already established that the sale of a partnership interest is the sale of a capital asset, it declined to follow Revenue Ruling 91-32.
Finally, the court determined whether GMM’s capital gain was U.S.-source income. U.S. tax law generally provides that income from the sale of personal property by a nonresident shall be sourced outside the United States. However, an exception referred to as the “U.S. office rule” states that if a nonresident maintains an office in the U.S., then income from the sale of personal property attributable to that office shall be sourced in the U.S. The court explored this exception and reached a conclusion based on two facts:
- The office itself was not a material factor in the income’s production.
- The partnership interest redemption was an extraordinary event, and the partnership was not itself in the business of redeeming partnership interests.
Because of these factors, the Tax Court determined that the gain was not attributable to the U.S. office and therefore was not U.S.-source income.