The recent decision in Grecian Magnesite revives a longstanding debate within the tax community over whether a partnership should be treated as an aggregate or an entity for tax purposes. The answer to that question, of course, is “it depends.” Several of our clients in the technology industry with foreign-owned U.S. partnerships in their operating structures have taken a keen interest in the ruling.
In Grecian Magnesite, the tax court rejected the aggregate approach of the Internal Revenue Service (IRS) in Rev. Rul. 91-32, which effectively treated gain on the sale of a partnership interest by a foreign partner as the sale of the partner’s interest in partnership assets in determining that the gain was effectively connected with the U.S. business conducted by the partnership. In short, the tax court observed that gain or loss from the sale of a partnership interest generally is treated as arising from the disposition a capital asset that is distinct from the underlying assets of the partnership itself. Thus, the partner’s gain was attributable to the sale of an interest in the partnership as an entity, rather than in the underlying assets. The result in Grecian Magnesite raises the question whether entity treatment of a partnership can prevail over aggregate treatment in other situations. One such situation is the application of Section 267 to payments between partnerships and persons related to the partnership.
In the domestic context, Section 267 has two functions. Section 267(a)(1) disallows or defers losses recognized on the sale of property between related parties; and Section 267(a)(2) requires matching the timing of income and deduction items resulting from a payment between related parties. In the international context, Section 267(a)(3) applies this matching principle to payments by U.S. taxpayers to related foreign persons. The matching principle is particularly important in cross-border situations, because foreign persons are generally subject to tax on income that is not effectively connected to a U.S. trade or business (such as interest on inbound loans) only when payment is made.
Similar to the rules at issue in Grecian Magnesite, the language used by Congress in, Section 267 demonstrates a clear intention to treat partnerships as entities rather than aggregates (see Section 267(e) for further support). One planning opportunity inherent in this conclusion is this: A foreign parent corporation could organize a domestic partnership for the purpose of holding loans to its domestic subsidiaries to ensure deductibility without regard to whether the interest was paid (i.e., Section 267 would not apply because the lender was a U.S. person). If loans were made directly by the foreign parent, unpaid interest on those loans would not be deductible by the subsidiaries under Section 267. However, holding the loan through a domestic partnership could allow the domestic subsidiaries to deduct the interest without paying it within the same year.
It is at least questionable whether a partnership organized solely for the purpose of obtaining an interest deduction that would otherwise be deferred under Section 267 could succeed under certain anti-abuse rules of Treasury Regulation 1.701-2 (Subchapter K Anti-Abuse) and Section 7701(o) (Economic Substance Doctrine). It should be noted that Section 1.701-2(a) requires that partnership transactions be entered with a substantial business purpose, and it is well established that tax avoidance is not a business purpose within the meaning of the tax law. However, there may well be situations in which business considerations dictate that loans should be made by a related domestic partnership, even if the partnership is owned directly or indirectly by a foreign parent. In such a case, the clear intention of the Code to apply Section 267 on an entity rather than aggregate basis should be respected, and the interest deduction should be allowed without regard to the timing of payment (subject to any other requirements for interest to be deductible) or to the fact that interest income is included in the distributive share of a related foreign corporation.
Look out for more detailed coverage on this idea in a soon to be released Tax Advisor Weekly!
Author: Alan Cathcart
 Grecian Magnesite Mining, Industrial & Shipping Co. v. Commissioner, 149 T.C. No. 3 (July 13, 2017). For a discussion of this case see “Tax Court’s Grecian Formula Combs in Colorable Claims for Refunds by Foreign Taxpayers”.
 Section 163(e)(3)(A) applies the matching principle to original issue discount on debt issued by a U.S. person to a related foreign person.