The recent legislation commonly called the “Tax Cuts and Jobs Act” (the “TCJA”) made many significant changes to the U.S. income taxation of international investments. One of these changes affects the U.S. income taxation of a foreign person (i.e., a person who is neither a U.S. citizen nor resident for U.S. income tax purposes) who has sold or exchanged an ownership interest in a domestic entity that is taxed as a partnership for U.S income tax purposes (e.g., a general partnership, limited partnership or limited liability company formed under the laws of any state within the U.S.). Although this recent change makes clear that, beginning on November 27, 2017, foreign persons will generally be liable for U.S. income tax in connection with their sales of U.S. partnership interests, this recent change also strengthens the position that certain foreign persons who sold or exchanged their interests in U.S. partnerships prior to November 27, 2017 were not subject to the U.S. income tax in connection with those sales or exchanges.
As a result, a foreign person who paid U.S. income tax in connection with their disposition of a U.S. partnership interest prior to November 27, 2017 should consider whether to claim a refund of that U.S. income tax. Foreign taxpayers will want to act quickly. Claims for refund of U.S. income tax generally must be filed within three years of the date the return was filed on which the income tax was originally reported.
Thus, time is of the essence in determining whether a foreign person is eligible to claim a refund of U.S. income tax in this situation. The following is a brief summary of the U.S. income tax authorities relevant to this determination.
Historically, the law was unsettled regarding whether a foreign person was required to pay U.S income tax on the gain recognized from the sale or exchange of an ownership interest in a domestic partnership. The Internal Revenue Service’s position, however, was that a foreign person is required to pay U.S. income tax on the gain recognized from the sale or exchange of a U.S. partnership interest to the extent that the income from a hypothetical sale by the U.S. partnership of its assets would have been taxable in the U.S. as income effectively connected with a U.S. trade or business. See Rev. Rul. 91-32, 1991-1 C.B. 107.
A Revenue Ruling is not binding on federal courts and merely represents the IRS’s position on an issue as a party to litigation. See Estate of Lang, 64 T.C. 404, 407-08 (1975). Nevertheless, a conservative foreign taxpayer wishing to avoid controversy may have opted to report and pay U.S. income tax in connection with the disposition of a U.S. partnership interest because of the IRS’s published position in Rev. Rul. 91-32.
The Grecian Magnesite Decision.
The U.S. Tax Court, in Grecian Magnesite, addressed whether a foreign taxpayer was required to pay U.S. income tax in connection with the exchange of an interest in a U.S. partnership. See Grecian Magnesite Mining, Indus. & Shipping Co., S.A. v. Comm’r, 149 T.C. No. 3 (July 13, 2017). The taxpayer (“Taxpayer”) in Grecian Magnesite was a foreign corporation (organized under the laws of Greece) that owned an interest in a limited liability company (“Premier”) organized in Delaware. The Taxpayer did not have any office, employees or business operations in the United States.
Premier mined and extracted magnesite from locations within the United States and produced and distributed that magnesite. Premier was headquartered in Pennsylvania and owned mines or industrial properties at various locations within the United States.
In 2008, the Taxpayer agreed to redeem its ownership interest in Premier in exchange for payments totaling $10.6 million. The redemption payments resulted in $6.2 million of gain recognized in connection with the redeemed interest. Of this total amount, $2.2 million of gain was attributable to Premier’s real property located in the United States. The Taxpayer, however, did not report any gain for U.S. income tax purposes in connection with the redemption.
The IRS issued a statutory notice of deficiency alleging that the Taxpayer should have reported gain of $6.2 million from the redemption for U.S. income tax purposes. The IRS also imposed the accuracy-related penalty under I.R.C. Section 6662 and the penalty for delinquent payment of tax under I.R.C. Section 6651(a)(2).
The Taxpayer and IRS eventually agreed that the $2.2 million of gain attributable to Premier’s U.S. real property was required to be recognized and taxed for U.S. income tax purposes under I.R.C. Section 897(g), which basically provides that the gain from sale of a U.S. partnership interest may be treated as received from the sale of U.S. real property (and thus subject to U.S. income taxation) to the extent that gain is attributable to U.S. real property owned by the U.S. partnership. In contrast, the U.S. taxability of the remaining $4 million of gain that was not attributable to Premier’s U.S. real property remained subject to dispute and was addressed by the Tax Court’s decision.
The Tax Court ultimately concluded that the remaining $4 million of gain was not subject to U.S. income taxation. In doing so, the Court relied on the statutory language of the Internal Revenue Code and specifically declined to follow Rev. Rul. 91-32, which the Court concluded was unpersuasive and based on analysis that was “cursory in the extreme.”
Grecian Magnesite stands for the proposition that a foreign taxpayer, who is neither a U.S citizen nor resident and who does not have any office, employees or direct business operations in the United States, is generally not subject to U.S. income tax on the gain recognized in connection with the sale or exchange of a U.S. partnership interest. The Grecian Magnesite decisionis significant because it contradicts the IRS’s longstanding ruling policy that would have required U.S income taxation in that situation.
The Tax Cuts and Jobs Act.
Congress did not wait long to statutorily overrule the Grecian Magnesite decision. The TCJA resulted in the enactment of I.R.C. Section 864(c)(8), which essentially adopts the IRS’s ruling position in Rev. Rul. 91-32. Section 864(c)(8) provides that a foreign person who sells or exchanges an interest in a U.S. partnership must recognize gain for U.S. income tax purposes to the extent that the gain recognized from a hypothetical sale by the U.S. partnership of its assets would have been effectively connected with the conduct of a U.S. trade or business.
Significantly, Congress made the new Section 864(c)(8) effective for sales or exchanges of U.S. partnership interests occurring on or after November 27, 2017. (This was the date on which the proposal for Section 864(c)(8) was first passed in the Senate.) Thus, a foreign taxpayer’s sale of a U.S. partnership interest occurring in 2018 will generally be subject to U.S. income tax.
Section 864(c)(8), however, adds further support to the position that a foreign person’s sale of a U.S. partnership interest occurring prior to November 27, 2017 was not subject to U.S. income tax in certain circumstances like that of the Grecian Magnesite decision. By changing the law prospectively, Congress has supported that the Grecian Magnesite decision is controlling for periods prior to the effectiveness of the new Section 864(c)(8).
Claims for Refund of U.S. Income Tax.
To timely claim a refund of U.S. income tax, a taxpayer generally must file the refund claim with the IRS prior to the later of: (i) three years following the date on which the taxpayer filed the U.S. income return reporting that tax; or (ii) two years following the date on which the taxpayer paid that tax. See I.R.C. Section 6511(a). Thus, the aforementioned limitations period for filing a refund claim is currently expiring for U.S. income taxes that were timely reported and paid in connection with the 2014 tax year. (Income tax returns for 2014 would have been timely filed in 2015, and three years from filing would expire during 2018.)
As more time passes, the period for which foreign taxpayers can claim a refund of U.S. income tax on the basis of the Grecian Magnesite decision shrinks. Thus, if a foreign taxpayer has paid U.S. income tax in connection with selling or exchanging its interest in a U.S. entity taxed as a partnership, that foreign partner should quickly take steps to evaluate whether they are eligible to claim a refund of that tax under the rationale of the Grecian Magnesite decision. Failure to do so may result in the loss of refunds that are supported by U.S. Tax Court authority. If anyone has any questions regarding whether they are eligible to claim a refund on the basis of the Grecian Magnesite decision or would like assistance with filing such a refund claim, please do not hesitate to contact Stephen Beck at 214-749-2401 or email him at firstname.lastname@example.org.