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July 26, 2017

Rejoice: investment into the U.S. may have just gotten cheaper, and many inbound investors may be entitled to refunds. Only a few short days after the Treasury Department issued Notice 2017-38 (identifying overly burdensome or complex regulations potentially subject to repeal), the Tax Court offered its own rebuke of a controversial IRS position, Revenue Ruling 91-32. And with that decision, Rev. Rul. 91-32 may have finally been laid to rest in a decision of relevance to nearly all inbound U.S. partnership investments.

On July 13, the U.S. Tax Court issued its decision in Grecian Magnesite Mining, Industrial & Shipping Co. SA v. Commissioner, a decision that will likely change future tax implications and that may hold substantial refund claim possibilities for foreign persons (i.e., nonresident alien individuals and foreign corporations) who disposed of interests in partnerships that conduct(ed) business in the U.S.


Generally, foreign persons are only subject to U.S. tax on two types of income: fixed or determinable annual or periodical gains, profits and income (known as “FDAP income”) from U.S. sources; and income that is effectively connected with the conduct of a U.S. trade or business (“ECI”).

As a general rule, capital gains are not treated as FDAP income. Therefore, as a general rule, capital gains of foreign persons would only be subject to U.S. tax to the extent that such gains are treated as ECI.

While the rules establishing what is and what is not ECI are extremely complex, they generally provide that a capital gain may only be considered ECI if either:

A) The asset disposed of was held for use in the conduct of a U.S. trade or business; or

B) The taxpayer’s business activities in the U.S. were a material factor in the realization of the gain.

As a result, a foreign person who is not engaged in (or deemed to be engaged in) the conduct of a U.S. business is not subject to U.S. tax on the disposition of a capital asset (with the exception of assets that are treated as United States real property interests). Thus, for example, a foreign person who realizes a gain on the sale of stock in a U.S. corporation and who has no other U.S. activities will not generally be subject to U.S. tax on such gain (unless the corporation is a United States real property holding corporation).

Where foreign persons’ U.S. activities and/or investments are held in corporate form, the analysis is fairly straightforward. If the corporation is not a U.S. real property holding corporation, the disposition of its shares by the foreign owner is not subject to U.S. tax. However, when the U.S. activities and/or investments are held in partnership form, it becomes a far more complex issue. Generally, partners in a partnership are treated as directly engaged in the activities of the partnership. Therefore, when a U.S. partnership is engaged in a U.S. trade or business, all its partners (including foreign ones) are similarly treated as engaged in a U.S trade or business. The result is that a foreign person with a seemingly passive investment interest in a U.S. partnership is subject to U.S. tax on the partnership’s ECI and U.S. source FDAP income, as if the foreign partner were directly carrying out the activities and holding the assets and liabilities of the partnership.

Revenue Ruling 91-32

The attribution of the activities and assets of a partnership to its partners is commonly described as the “aggregate theory” of partnership taxation. This contrasts with the “entity theory,” which generally acknowledges a separation between partners and partnerships in transactions involving partnership interests. The question of the tax treatment of a foreign person’s capital gain on the sale of a partnership interest is almost entirely a question of whether the aggregate theory or the entity theory governs the transaction. In issuing Rev. Rul. 91-32, the Service firmly ruled that the aggregate theory should govern.

In applying the aggregate theory, Rev. Rul. 91-32 interprets the sale of a partnership interest as a partner selling its proportionate share of the partnership assets and liabilities, rather than selling any sort of capital interest in the partnership entity. For a foreign person, this interpretation carries significant (and typically adverse) tax implications.

As described above, a foreign person will generally not be subject to tax on sales of assets unless such assets are related to its U.S. trade or business. However, if that person is instead treated as selling its proportionate interest in assets that are used as part of its U.S. trade or business, those capital gains may be treated as ECI. Needless to say, the ruling was immediately controversial, and many practitioners questioned its validity and have eagerly awaited a challenge in the courts. Fortunately, all good things come to those who wait.

Grecian Magnesite

This case involved a Greek company, Grecian Magnesite, that held a U.S. partnership interest in the early 2000s. For each year that Grecian Magnesite held that interest, it properly filed a U.S. tax return and paid tax on its distributive share of ECI generated by the partnership.

In 2008, the partnership redeemed Grecian Magnesite’s partnership interest in a transaction treated as a sale of the interest, generating a capital gain for the company. Under the advice of its tax advisor, Grecian Magnesite did not report the gain as ECI and did not pay U.S. tax on any of the gain. Some of the gain was attributable to U.S. real property interests held by the partnership, which should have been recognized as taxable under the U.S. tax rules dealing with foreign investment in U.S. real property (under the Foreign Investment in Real Property Tax Act of 1980, or FIRPTA). However, the majority was not. The IRS assessed Grecian Magnesite for the unpaid tax on the entire gain. The company conceded that the FIRPTA portion of the gain was properly assessable, but countered the IRS’s claim that the remainder of the gain should also be subject to U.S. tax as ECI, directly challenging the validity of Rev. Rul. 91-32.

The Court’s opinion focuses heavily on whether, in such a transaction, the aggregate or entity theory should apply. In a taxpayer-friendly result, the entity theory won out. Specifically citing the statutory language of Sec. 741, the Court held that gains or losses on sales of partnership interest should be treated as gains or losses on the sale of a capital asset (except as otherwise provided in the Internal Revenue Code). In particular, the Court pointed to Sec. 741’s use of the singular “asset,” which would refer to the partnership interest, rather than the plural “assets,” which could be interpreted as a reference to the assets held by the partnership.

Further, what the IRS may have thought was its strongest argument perhaps did more to undermine than support its case. The Service argued that the aggregate theory must be relevant in the sale of a partnership interest, otherwise the FIRPTA look-through rules could not apply (i.e., the partner could not be treated as selling its proportionate share of the partnership’s real property assets). Therefore, if the taxpayer concedes that FIRPTA should apply, then the aggregate theory must govern the transaction.

The Court swiftly and assuredly steamrolled this argument. In its opinion, the Court pointed out that if the aggregate theory applied to the transaction, there would never be a need for the FIRPTA look‑through rules for partnerships in the first place — a foreign person would be subject to tax on its share of all of a partnership’s assets, not simply the real property assets. That is, the existence of the exception for U.S. real estate assets is evidence of the contrary rule for other assets.

What to Expect from the IRS

It should be noted that the Service has not yet responded to the decision in Grecian Magnesite. The fact that the IRS lost in Grecian Magnesite does not necessarily mean that it will immediately begin granting refund claims. Generally, the IRS has several options available after losing a tax dispute at the trial court level. First, it may appeal the decision to the U.S. Court of Appeals. Alternatively, it may choose not to appeal that particular case, but to continue taking the same position for other cases. And third, it may decide not to appeal and to adopt the position taken by the court.

Apart from its decision of whether or not to appeal, it is possible that the IRS may formally announce whether or not it will follow the Tax Court’s decision in Grecian Magnesite. Sometimes, usually when following a loss in a court decision that it chooses not to appeal, the Service will issue a notice that is referred to an “action on decision” (AOD), announcing that it intends to either “acquiesce” or “non-acquiesce” to the court’s decision. More often than not, it seems that AODs announce decisions to non-acquiesce. Of the eight AODs issued since the beginning of 2016, six are non-acquiescences.

Alvarez & Marsal Taxand Says:

The significance of Grecian Magnesite to many non-U.S. taxpayers cannot be overstated. While some foreign investors have taken positions contrary to Rev. Rul. 91-32 based on the belief that the ruling was invalid, a great many more have likely paid substantial taxes in accordance with the ruling. For foreign partners who have paid tax on capital gains in recent years, there may be money on the table to be recovered from the IRS. Affected taxpayers should begin by identifying whether the statute remains open for the year(s) for which tax was paid and then consider whether to pursue a refund. Typically, this is done by filing an amended U.S. Federal income tax return requesting the refund. But in some circumstances, it may be possible and desirable to raise the refund request in connection with an audit or litigation of other tax issues.

It is also important to note that this case may open up the possibility of filing refund claims with any states to which the taxpayer paid taxes on the disposition of a partnership interest.

Taxpayers should also understand that the filing of a refund claim may not, in and of itself, produce a refund. Unless the Service (or the state tax authority) decides to change its position, it may be necessary for taxpayers to go to court to challenge the denial of the refund claim by the IRS (or the state tax authority). 


The information contained herein is of a general nature and based on authorities that are subject to change. Readers are reminded that they should not consider this publication to be a recommendation to undertake any tax position, nor consider the information contained herein to be complete. Before any item or treatment is reported or excluded from reporting on tax returns, financial statements or any other document, for any reason, readers should thoroughly evaluate their specific facts and circumstances, and obtain the advice and assistance of qualified tax advisers. The information reported in this publication may not continue to apply to a reader's situation as a result of changing laws and associated authoritative literature, and readers are reminded to consult with their tax or other professional advisers before determining if any information contained herein remains applicable to their facts and circumstances.

About Alvarez & Marsal Taxand

Alvarez & Marsal Taxand, an affiliate of Alvarez & Marsal (A&M), a leading global professional services firm, is an independent tax group made up of experienced tax professionals dedicated to providing customized tax advice to clients and investors across a broad range of industries. Its professionals extend A&M's commitment to offering clients a choice in advisers who are free from audit-based conflicts of interest and bring an unyielding commitment to delivering responsive client service. A&M Taxand has offices in major metropolitan markets throughout the United States and serves the United Kingdom from its base in London.

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