Coming to America
Whether they are acquiring an interest in U.S. real property or in a U.S. operating company, foreigners seek to structure their U.S. investments in a tax-efficient manner, so as to reduce their U.S. income tax liability with respect to both the current profits generated by the investment and the gain realized on the disposition of the investment, thereby increasing the return on their investment.
A recent decision by the U.S. Tax Court may mark a significant development in the taxation of the gain realized by a foreigner on the sale of its interest in a U.S. partnership.
Investment in Partnership
Taxpayer was a privately-owned foreign corporation that owned a minority membership interest in LLC, a U.S. limited liability company that was treated as a partnership for U.S. income tax purposes. Taxpayer had no office, employees, or business operation in the U.S.
In 2008, LLC agreed to redeem Taxpayer’s membership interest; as a matter of state law, the redemption was to be effective as of December 31, 2008. LLC made two payments to Taxpayer – the first in 2008 and the second in 2009. Taxpayer realized gain on the redemption of its interest.
With its 2008 Form 1065, “U.S. Return of Partnership Income,” LLC included a Schedule K-1 for Taxpayer that reported Taxpayer’s share of LLC’s income, gain, loss, and deductions for 2008. Consistent with that Schedule K-1, Taxpayer filed a Form 1120-F, “U.S. Income Tax Return of a Foreign Corporation,” for 2008, on which it reported its distributive share of LLC’s income, gain, loss, and deductions. However, LLC did not report on that 2008 return any of the gain it had realized that year on the redemption of its interest in LLC.
With its 2009 Form 1065, LLC included a Schedule K-1 for Taxpayer that – consistent with the agreement between Taxpayer and LLC that the redemption of Taxpayer’s entire membership interest was effective as of December 31, 2008 – did not allocate to Taxpayer any income, gain, loss, or deductions for 2009. As in 2008, Taxpayer took the position that the gain realized was not subject to U.S. tax; thus, Taxpayer did not file a U.S. tax return for 2009.
The IRS audited Taxpayer’s 2008 and 2009 tax years, and determined that Taxpayer should have recognized U.S.-source capital gain for those years from the redemption of its interest in LLC. This determination was based upon the IRS’s conclusion that, as a result of Taxpayer’s membership interest in LLC, its capital gain was effectively connected with a U.S. trade or business (“USTB”).
Taxpayer petitioned the U.S. Tax Court, where the issue for decision was whether the gain from the redemption of Taxpayer’s interest in LLC was U.S.-source income that was effectively connected with a USTB and, therefore, subject to U.S. taxation.
U.S. Taxation of Foreigners
Before reviewing the Court’s opinion, a brief description of how the U.S. taxes foreigners may be in order.
The income of a foreign corporation may be subject to U.S. income tax if: (1) the income is received from sources within the U.S. (“U.S.-source income”), and it is one of several kinds of income enumerated by the Code (including, for example, dividends, interest, and other “fixed or determinable annual or periodic” (“FDAP”) income); or (2) the income is “effectively connected with the conduct of” a trade or business conducted by the foreign corporation within the U.S. (“effectively connected income”).
In general, the gross amount of a foreigner’s FDAP income is subject to U.S. income tax (and withholding) at a flat 30% rate; no deductions are allowed in determining the tax base to which this rate is applied.
With some exceptions, the Code does not explicitly address the taxation of the capital gain realized by a foreigner on the sale of an equity interest in a U.S. business entity; rather, it is by virtue of addressing these exceptions that the general rule – that capital gain is not subject to U.S. tax – arises. Thus, the gain realized by a foreigner from the sale of a capital asset that is sourced in the U.S. is not subject to U.S. tax unless the asset is related to the foreigner’s USTB or the asset is “an interest in U.S. real property,” the sale of which is treated as effectively connected with a USTB.
In contrast to FDAP income, the foreigner is allowed to deduct the expenses incurred in generating its effectively connected income, and that net income is taxed at graduated rates.
Whether a foreigner is engaged in a USTB depends upon the nature and extent of the foreigner’s activities within the U.S. Generally speaking, the foreigner’s U.S. business activities must be “regular, substantial and continuous” in order for the foreigner to be treated as engaged in a USTB. In determining whether a foreigner’s U.S. activities rise to the level of a trade or business, all of the facts and circumstances need to be considered, including whether the foreigner has an office or other place of business in the U.S.
However, a special rule applies in the case of a foreigner that is a partner in a partnership that is, itself, engaged in a USTB; specifically, the foreigner shall be treated as being engaged in a USTB if the partnership of which such foreigner is a member is so engaged.
In that case, provided it is effectively connected with the conduct of a USTB, the foreigner partner must include its distributive share of the partnership’s taxable income in determining its own U.S. income tax liability.
Generally speaking, all income, gain, or loss from sources within the U.S., other than FDAP income, is treated as effectively connected with the conduct of a USTB.
Points of Agreement
Taxpayer conceded that it was engaged in a USTB by virtue of its membership interest in LLC. In fact, Taxpayer reported on Form 1120-F, and paid U.S. income tax on, its distributive share of LLC’s operating income for every tax year that it was a member of LLC, including the year in which its membership interest was redeemed.
In addition, both Taxpayer and the IRS agreed that no part of the redemption payments made to Taxpayer should be treated as a distributive share of partnership income.
The IRS also agreed with the Taxpayer that the payment made by LLC in redemption of Taxpayer’s membership interest should be treated as having been made in exchange for Taxpayer’s interest in LLC’s property. As such, the Taxpayer would recognize gain as a result of the redemption only to the extent that the amount of money distributed exceeded Taxpayer’s adjusted basis for its interest in LLC immediately before the distribution. This gain would be considered as gain from the sale or exchange of the Taxpayer’s membership interest.
In general, the gain realized on the sale of a partnership interest is treated as gain from the sale or exchange of “a capital asset.” According to Taxpayer, because the gain realized on the redemption of its membership interest was equivalent to the sale of a capital asset that was not used by Taxpayer in a USTB, it could not be subject to U.S. tax.
The IRS, however, viewed the issue differently. According to the IRS, Taxpayer’s gain did not arise from the sale of a single, indivisible asset – Taxpayer’s interest in LLC – but rather from the sale of Taxpayer’s interest in the assets that made up LLC’s business, in which Taxpayer was treated as having been engaged.
Aggregate vs. Entity
The IRS argued that the Court should employ the so-called “aggregate theory,” under which a partner’s sale of a partnership interest would be treated as the sale by the partner of its separate interest in each asset owned by the partnership.
The Court, however, rejected the IRS’s argument. It noted that the Code generally applies the “entity theory” to sales and liquidating distributions of partnership interests – it treats the sale of a partnership interest as the sale of “a capital asset” – i.e., one asset (a partnership interest) – rather than as the sale of an interest in the multiple underlying assets of the partnership.
The Court then pointed out that the Code explicitly carves out certain exceptions to this general rule that, when applicable, require that one look through the partnership to the underlying assets and deem the sale of the partnership interest as the sale of separate interests in each asset owned by the partnership; for example, where the partnership holds “hot assets,” or where it holds substantial interests in U.S. real property, in which case an aggregate approach is employed in determining the tax consequences of a sale.
Accordingly, the Court determined that Taxpayer’s gain from the redemption of its membership interest was gain from the sale or exchange of an indivisible capital asset: Taxpayer’s interest in LLC.
The Court then considered whether the gain realized on the redemption was taxable in the U.S., which depended upon whether that gain was effectively connected with the conduct of a USTB — specifically, whether that gain was effectively connected with the trade or business of LLC, which trade or business was attributed to Taxpayer by virtue of its being a member of LLC.
The IRS argued that the gain was “effectively connected,” pointing to one of its own published rulings, in which it held that the gain realized by a foreigner upon the disposition of a U.S. partnership interest should be analyzed asset by asset, and that, to the extent the assets of the partnership would give rise to effectively connected income if sold by the entity, the departing partner’s pro rata share of such gain should be treated as effectively connected income.
The Court, however, did not find the ruling persuasive, and declined to follow it. Instead, the Court undertook its own analysis of the issue.
It considered whether the gain from the sale of the membership interest was U.S.-source. Unfortunately, the Code does not specifically address the source of a foreigner’s income from the sale or liquidation of its interest in a partnership.
However, under a default rule for sourcing gain realized on the sale of personal property (such as a partnership interest), gain from the sale of personal property by a foreigner is generally sourced outside the U.S. In accordance with this rule, the gain from Taxpayer’s sale of its LLC interest would be sourced outside the U.S.
The IRS countered, however, that this gain fell under an exception to the default rule: the “U.S. office rule.” Under this exception, if a foreigner maintains a fixed place of business in the U.S., any income from the sale of personal property attributable to such “fixed place of business” is treated as U.S.-source.
Taxpayer’s gain would be taxable under this exception, the Court stated, if it was attributable to LLC’s office, which the Court assumed – solely for purposes of its analysis – would be deemed to have been Taxpayer’s U.S. office.
In order for gain from a sale to be “attributable to” a U.S. office or fixed place of business, the U.S. office must have been a “material factor in the production” of the gain, and the U.S. office must have “regularly” carried on – i.e., “in the ordinary course of business” – activities of the type from which such gain was derived.
The IRS contended: that the redemption of Taxpayer’s interest in LLC was equivalent to LLC’s selling its underlying assets and distributing to each member its pro rata share of the proceeds; that LLC’s office was material to the deemed sale of Taxpayer’s portion of LLC’s assets; and that LLC’s office was material to the increased value of LLC’s underlying assets that Taxpayer realized in the redemption.
The Court responded that the actual “sale” that occurred here was Taxpayer’s redemption of its partnership interest, not a sale of LLC’s underlying assets. In order for LLC’s U.S. office to be a “material factor,” that office must have been material to the redemption transaction and to the gain realized.
The Court noted that Taxpayer’s redemption gain was not realized from LLC’s trade or business, that is, from activities at the partnership level; rather, Taxpayer realized gain at the partner-member level from the distinct sale of its membership interest. Increasing the value of LLC’s business as a going concern, it explained, is a distinct function from being a material factor in the realization of income in a specific transaction. Moreover, the redemption of Taxpayer’s interest was a one-time, extraordinary event, and was not undertaken in the ordinary course of LLC’s business – LLC was not in the business of buying and selling membership interests.
Therefore, Taxpayer’s gain from the redemption of its interest in LLC was not realized in the ordinary course of the trade or business carried on through LLC’s U.S. office, it was not attributable to a U.S. fixed place of business and, therefore, it was not U.S.-source.
Consequently, the gain was not taxable as effectively connected income.
It Isn’t Over ‘til the Weight-Challenged Person Sings
The Tax Court’s decision represents a victory for foreigners who invest in U.S. businesses through a pass-through entity such as a partnership or limited liability company – how significant a victory remains to be seen.
First, the IRS has ninety days after the Court’s decision is entered in which to file an appeal to a U.S. Court of Appeals. Query whether that Court would be more deferential to the IRS’s published ruling, describe above.
Second – don’t laugh – Congress may act to overturn the Tax Court’s decision by legislation. “Why?” you may ask. Foreigners who rely upon the decision will not report the gain from the sale of a partnership interest. If the partnership has in effect an election under section 754 of the Code, the partnership’s basis in its assets will be increased as a result of the sale (as opposed to the liquidation/redemption) of the foreigner’s partnership interest. This will prevent that underlying gain from being taxed to any partner in the future.
Third, the decision did not address how it would apply to “hot assets” — for example, depreciation recapture. As noted above, the Code normally looks through the sale of a partnership interest to determine whether any of the underlying assets are hot assets. Where the foreign partner has enjoyed the benefit of depreciation deductions from the operation of the partnership’s USTB – thereby reducing the foreigner’s effectively connected income – shouldn’t that benefit be captured upon the later sale of the foreigner’s partnership interest?
Finally, there is a practical issue: how many foreigners will invest through a pass-through entity rather than through a U.S. corporation? Although a corporate subsidiary will be taxable, its dividend distributions to the foreign parent will be treated as FDAP and may be subject to a reduced rate of U.S. tax under a treaty. The foreigner’s gain on the liquidation of the subsidiary will not be subject to U.S. tax. Moreover, the foreigner will not have to file U.S. returns.
Stay tuned. In the meantime, if a foreigner has paid U.S. tax in connection with the redemption of a partnership interest – on the basis of the IRS ruling rejected by the Tax Court – it may be a good idea to file a protective refund claim.