The US Tax Court recently made changes to long-standing US policy for the taxation of the sale of a non-resident foreign partner’s interest in a US trade or business partnership. Generally, the US taxes non-resident foreign persons only on US sourced capital gains. Consequently, the US has historically only taxed capital gains of non-resident foreign persons if the property sold was real estate, timber or mineral interests sourced in the US or property “effectively connected with a US trade or business”.
Under this policy, the gain on personal property, including corporate stock, bonds and other securities, is not subject to taxation in the US if the seller is a non-resident foreign person. However, under Revenue Ruling 91-32, the gain on the sale of a partnership interest was deemed to be income “effectively connected to a US trade or business”. Thus, under Revenue Ruling 91-32, when selling their interest in a partnership, a foreign partner was deemed to be selling their respective share of each of the partnership’s underlying assets and was subject to US taxation on the entire gain if those assets were deemed to be effectively connected to the partnership’s US trade or business.
However, in a recent case (Grecian Magnesite Mining v. Commissioner, 149 T.C. No. 3) the Tax Court declined to follow Revenue Ruling 91-32 and held that the sale of the foreign person’s gain on the sale of their interest in the partnership was not effectively connected with a U.S. trade or business and would only be taxable to the extent the gain was allocable to US real estate owned by the partnership.
In effect, the Tax Court treated the gain on the sale of the interest in a trade or business partnership in the same manner they would if it were the sale of corporate stock owned by the non-resident foreign person. This ruling may and probably will be appealed by the IRS. But, if it stands, it will remove one of the obstacles for using partnerships when considering entity choice for new foreign owned US businesses.