Tax Court Declines to Follow Rev. Rul. 91-32 – Important Development for Foreign Investors!
On July 13, 2017, the U.S. Tax Court (Tax Court) issued a 55-page opinion rejecting the long-standing position of the Internal Revenue Service (IRS) as outlined in Revenue Ruling 91-321 concerning the sale by a foreign person of an interest in a partnership that is engaged in a U.S. trade or business for U.S. federal income tax purposes.
Specifically, in this taxpayer victory, the Tax Court held that the foreign partner’s gain from the redemption of its partnership interest by a U.S. partnership (to the extent it was not attributable to U.S. real estate) was not U.S.-source income and was therefore also not gain effectively connected with a U.S. trade or business, thereby exempting such gain from U.S. taxation.
This opinion, which the IRS may challenge on appeal, is potentially good news for foreign investors in U.S.-focused investment funds, joint ventures or investments in U.S. operating companies treated as partnerships for U.S. tax purposes.
Summary of the Case
In 2001, GMM, a foreign corporation, purchased an interest in Premier, a U.S. limited liability company treated as a partnership for U.S. income tax purposes. From 2001 to 2008, income was allocated to GMM from Premier, and GMM paid income tax in the U.S. In 2008 GMM's interest was redeemed by Premier, and GMM received two liquidating payments, one in July 2008 and the second in January 2009. GMM realized gain totaling over $6.2 million, of which $2.2 million was deemed attributable to U.S. real property interests (which GMM conceded was taxable under the FIRPTA rules of Code §897(g)).
The court held that the non-FIRPTA portion of the gain ($4 million, referred to by the court as the "disputed gain") was capital gain that was not U.S. source income. As a result, the disputed gain was not effectively connected with a U.S. trade or business and was not subject to U.S. income tax. The court applied the "entity theory" (as opposed to the "aggregate theory") with respect to the sale or exchange of the interest in the partnership. The court declined to follow the Rev. Rul. 91-32.
In discussing Rev. Rul. 91-32, the court stated:
Rev. Rul. 91-32 is not simply an interpretation of the IRS's ambiguous regulations, and we find that it lacks the power to persuade. Its treatment of the partnership provisions discussed above in part II.B is cursory in the extreme, not even citing section 731 (which, as we set out, yields a conclusion of “gain or loss from the sale or exchange of the partnership interest” * * *.
The ruling's subchapter K analysis essentially begins and ends with the observation that “[s]ubchapter K of the Code is a blend of aggregate and entity treatment for partners and partnerships.” We criticize the ruling's treatment of the subchapter N issues in notes 22 and 24 below. We decline to defer to the ruling. Instead, we will follow the Code and the regulations to determine whether the disputed gain is effectively connected to income.
The court echoed arguments that have been made in numerous articles criticizing Rev. Rul. 91-32 since its release over 25 years ago. The Obama administration also tried to codify the result of Rev. Rul. 91-32, which could reasonably be interpreted as a concession that Rev. Rul had no statutory authority. 91-32 in the first place. Given the thrashing the IRS received from the court on seemingly every argument it made in the opinion, it is surprising that it has taken over 25 years for a court dismiss Rev. Rul. 91-32.