U.S. Tax Court Monumental Ruling Will Impact Foreigners with U.S. Businesses or Investments
A precedent-setting ruling recently issued by the U.S. Tax Court changes the way foreigners are taxed in the United States. The ruling states that a foreigner involved in business or investment activity in the United States through a partnership can sell its share of the partnership without paying U.S. capital gains tax, with a special exception for cases where the partnership in involved in real estate activity in the United States (FIRPTA).
The 55-page ruling issued on July 13, 2017 opens a window for tax planning by foreign investors who have activity in the U.S. through partnerships. In the case at hand, a Greek company called Grecian Magnesite Mining acquired 12.6% in Premier Chemicals, a U.S. LLC headquartered in the U.S. (Under U.S. tax law, the LLC is usually treated as a pass-through partnership).
The Greek company itself had little connection with the U.S. - no offices, no workers, no business.
At a certain stage, the Greek company sold its share in the LLC and received $ 10.6 million, of which $ 6.2 million was capital gain. The IRS claimed that all capital gains should be taxed in the U.S. because the gain was associated with U.S. business activity.
At the heart of the dispute were two different approaches to how a partnership is treated. According to one approach favored by the Greek company, the separate entity theory, partnerships should be treated as a separate legal entity for tax purposes - separate from the partnership assets. The result is that the transfer of a partner's share in a partnership is considered as the sale of a single asset (the partnership interest), just like the sale of a share in an American corporation. As a rule, the U.S. does not impose capital gains tax on profits of a foreigner from the sale of U.S. securities.
According to the second approach, the aggregate theory, which the IRS supported, each partner holds a part of each asset of the partnership, and when a partner sells his share in the partnership, it is as if he sold a proportionate share of the partnership assets. And in this case, any gain is subject to U.S. capital gains tax.
The court rejected the IRS position. The judge ruled that with regard to the sale of partnership interests, the separate entity theory should be used. In other words, when the partner sells his share, he sells an indivisible asset - not his share of the partnership's assets.
Given the impact of the decision, it took the court three years to issue the judgment. And although the decision was signed by one judge, it was made after intense consultations with other judges. It is work noting that the author worked for a U.S. Tax Court judge and drafted opinions that involved important issues. In such cases, the issued were debated inside the court before a ruling was issued. But not three years!
The Federal Tax Court did not stop here. To overcome the first setback, the IRS proposed an alternative theory to support taxation of the gain: tax should be imposed because the gain was “effectively connected to a U.S. trade or business.”
For decades, under Revenue Rule 91-32, the IRS position was that income or gain that was “effectively connected to a U.S. trade or business” was subject to U.S. tax. Here too Tax Court dealt the IRS with a stinging defeat.
The court divided the analysis into two parts. In the first part, it stated that even if the partnership has American-based activity and an office, there must be a substantial connection between the revenues and profits attributed to the foreign partner and the American presence. The U.S. presence must contribute meaningfully to the revenue and profits. In other words, an Israeli partner of a partnership (American or foreign partnership) active in the U.S. pays US taxes on his share in profits if his activity is materially related to the US.
For example, if the foreign partner is responsible for the activity in its own country, and not in the US, it clearly must be determined what value, if any, the U.S. office had in the Partner’s income/profit/gains/promote.
In the second part, the court ruled that there must be a significant connection between the nature of profit and the daily operational activity in the U.S. In this case, the court ruled that while the operating profits grew in the U.S. and are therefore subject to income tax, this is not the case with respect to capital gains. The reason is that the court ruled that the regular business of the partnership is not buying and selling partnership interests. The partnership ran an operational mining business. And there is not sufficient connection between an increase in the value of the partnership and daily business activity. Hence the appreciation in value does not justify the imposition of capital gains!!!
It is important to note that the court did not address the question of the implications of the U.S. - Greece tax treaty. Rather, the court stated that since there is no tax liability under American law, there is no need to base the decision on the treaty and the additional protections it grants.
Beyond the importance of the ruling for partners selling partnership interests, the decision has implications for non-US persons who have some business/investment presence in the U.S. The foreign partner’s exposure to U.S. tax on bonuses, profits and promote will no longer be automatic, but based on circumstances. There is much room for planning here.
The court excepted U.S. real estate from the capital gains tax analysis, but nevertheless the ruling has potential implication for foreign investors in US real estate - in the context of estate tax.
Many non-US persons invest in the U.S. real estate, and these investments are often carried out through an LLC, which is considered a partnership under U.S. tax laws. If the investment is more than $60,000, then according to estate tax laws, after the death of the investor, the estate must pay a tax that can reach 40% of the value of the assets - even if the investors have no connection to the U.S. at all, besides their real estate investment.
Now, after the Tax Court ruling, one can argue that the real estate investor’s share in the LLC (a partnership) is not considered a holding in real estate, but rather a holding of an intangible that is not subject to estate tax. This is a possible expansionary interpretation of the ruling, according to which the Israeli partner is not considered a holder of tangible real estate assets in the United States, but only a holder of a partnership interest. Under the U.S. estate tax law, foreigners may not be subject to the tax for such assets.
After the stinging defeat, it is likely that the IRS will appeal the ruling. Such a procedure will probably take a few more years, and in any case, until then the ruling is the law. Another possibility is that the U.S. Department of Treasury will issue regulations that adopt the IRS position. Such regulations would over-rule the Court’s decision. However, in view of the current situation of Trump and Congress, it is not likely at all that this matter will be high up on the priority list. So now is the time to plan accordingly.
ABOUT THE AUTHOR: Monte Silver
For over two decades MS has been providing U.S. tax counsel to entities and high-wealth individuals, including (i) U.S. Persons on issues of tax, disclosure, or citizen/residency matters & (ii) non-U.S. persons with U.S. business/investment matters. Previously worked at I.R.S. Estate & Gift Tax Division & U.S. Tax Court.
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Disclaimer: While every effort has been made to ensure the accuracy of this publication, it is not intended to provide legal advice as individual situations will differ and should be discussed with an expert and/or lawyer. For specific technical or legal advice on the information provided and related topics, please contact the author.