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By Kimberly S. Blanchard, Esq.
Weil, Gotshal & Manges LLP, New York, NY
Field attorney advice memorandum FAA 20123903F was released on September 28, 2012, but published only this past March. It is to my knowledge the only publicly available expression of the IRS's current view on the application of Rev. Rul. 91-32 since that revenue ruling was issued in 1991. It is impossible to know whether the application of that ruling has arisen in other audits and subsequently settled. It is interesting to wonder whether the IRS may have been emboldened to ferret out more of these cases in view of the Obama Administration's proposal to "codify" the published ruling.1
Rev. Rul. 91-32 required a foreign partner of a partnership engaged in a U.S. trade or business to report and pay U.S. tax on the sale of her partnership interest, to the extent gain on such sale was attributable to the assets used in the U.S. trade or business. FAA 20123903F involved precisely those facts, except that in the FAA the taxpayer had sold her partnership interest in exchange for a promissory note that had not yet come due. Thus, the only immediate question in the FAA was whether the taxpayer was subject to the installment sale interest charge regime of §453A.2
According to the FAA, the taxpayer had filed a written protest of an audit adjustment arguing that her gain was not taxable because, under §741, the sale of a partnership interest is a sale of a distinct and separate capital asset. This was a correct statement, as the FAA acknowledged. However, the FAA asserted that §864(c)(2) recharacterizes gain on the sale of a partnership interest as effectively connected income (ECI). It retraced the two essential steps of the analysis set out in the published 1991 ruling.
First, the IRS noted that §875(1) treats a foreign person as engaged in a U.S. trade or business if she is a partner in a partnership that is so engaged. From this it follows that the taxpayer here was in fact engaged in a U.S. trade or business. The FAA, however, does not discuss the relevance of this conclusion to the case at hand. As this author has pointed out, §875 is a distributive share rule; it operates to characterize a taxpayer's share of partnership income as ECI where the partnership is engaged in a U.S. trade or business.3 In such cases, §1446 requires the partnership to withhold an advance tax on a foreign partner's share of the partnership's ECI. Neither §875 nor §1446 has any effect on the character of gain from the sale or other disposition of a partnership interest by a partner herself, which occurs "outside" the partnership and, absent the application of the rules of FIRPTA, is not subject to withholding.4
Second, the FAA, like the published ruling, asserted that the asset use test of Regs. §1.864-4(c)(2) applied so as to characterize the gain on the sale of the taxpayer's partnership interest as ECI, because "the value of the U.S. trade or business activity of the partnership affects the value of the foreign partner's interest in this partnership" (emphasis added). The invocation of the asset use test to determine the character or gain on the sale of a partnership interest is simply untenable. The asset-use test applies only where the asset that was the subject of the sale was held or acquired in the course of the business being carried on. Here, the selling partner was quite clearly not in the business of selling partnership interests. And even if the business of the partnership is attributed to the selling partner, she did not sell any assets of that business so attributed to her. The partnership, of course, never owned an interest in itself, so the asset sold - the partnership interest - cannot have been attributed to the taxpayer from the partnership.
One cannot discern from the face of the FAA how the taxpayer's ECI was calculated. This was also a weakness in Rev. Rul. 91-32. In any case where less than all of a partnership's assets are used in a U.S. trade or business, or in any case where some of the partnership's assets have appreciated in value but others have depreciated in value, to speak in terms of gain "attributable" to the partnership's assets is to say nothing about how outside gain ought to be calculated. The failure to acknowledge this issue seems especially odd in the FAA, because the real question at issue was the calculation of the §453A interest charge, something that could not be done without knowing precisely the amount of the taxpayer's recognized gain on the sale.
The difficulty of determining the built-in gain or loss on various partnership assets is probably the reason that Congress decided to adopt an entity rule in §741. In a simple case, such as where all of a partnership's assets are used in a U.S. trade or business, all are held at a gain, the partnership's basis and holding period for its assets exactly match the selling partner's basis and holding period for her partnership interest, applying an aggregate rule would be simple, because 100% of the outside gain would clearly be attributable to the asset-level gain. It is a rare case, however, when all of these statements are true. Moreover, the selling partner would need to be in a position to discover the partnership's basis and holding period, or at least the amount of its built-in gain, in order to verify that this is true. But if one imagines a more typical case in which the partnership's assets have both built-in gains and losses, where some assets are held in connection with a U.S. trade or business and others are not, it may be very difficult or even impossible for the selling partner to determine the amount of gain that is "attributable" to her sale.
There is no question at all that §741 is a pure entity rule; a partnership interest has a basis and holding period distinct from the partnership's basis and holding period in its assets, and the sale of a partnership interest is the sale of a distinct capital asset. To preserve this regime, when Congress wanted to deny capital gain treatment to the sale of certain partnership interests, it did not do so by invoking aggregate theory. Instead, it enacted §751, which when applicable simply recharacterizes a portion of the seller's gain as ordinary income. Due to the difficulty of determining the basis, holding period, and character of all of a partnership's assets, §751 is limited to items that are usually large and knowable and, in some cases, exceed certain thresholds. Section 751 thus reinforces the basic entity rule of §741.
As the FAA and the published ruling both point out, the rules of Subchapter K reflect a blend of entity and aggregate principles. In ambiguous or close cases, the policy of the rule sought to be applied may lead to the application of either an entity or an aggregate approach. However, there is no room to argue for an aggregate approach to sales of partnership interests, which are explicitly made subject to the pure entity rule of §741.5 The partnership anti-abuse regulation, at Regs. §1.701-2(e), provides that the IRS can treat a partnership as an aggregate of its partners when appropriate to carry out the purpose of any provision of the Code. But by its terms, this rule does not apply, and the IRS thus has no discretion to apply aggregate principles, to the extent that a provision of the Code prescribes the treatment of the partnership as an entity and that treatment was clearly contemplated. There are few things clearer in Subchapter K than that §§741 and 751 prescribe entity treatment.
There are, of course, sound policy arguments in favor of Rev. Rul. 91-32. It is clear that if a foreign person sells a directly held asset used by her in a U.S. trade or business, any resulting gain or loss is ECI. It, therefore, seems strange that a foreign person could avoid this tax merely by owning U.S. assets in partnership with others; in an extreme case, the foreign person could form a captive partnership in which she held 99% of the interests and an affiliate held the remaining 1%. Of course, this type of planning could run afoul of the choice of entity provision in the anti-abuse rules just mentioned.6
The real concern to which these rulings are addressed is the tax-free step-up obtained by a buyer of a partnership interest where a §754 election is in effect. However, the availability of such an election, which reflects pure aggregate principles, in the context of a sale that, to the seller, is taxed under pure entity principles, has precisely this result. For this reason, the IRS and Congress have occasionally acted to narrow the application of the §754 election, for example, in order to avoid the duplication of losses.7 These actions show that even a very good policy argument cannot override clear, prescriptive rules contained in Subchapter K. Presumably this is one reason why the Obama administration has proposed to codify Rev. Rul. 91-32.
This commentary also will appear in the May 2013 issue of the Tax Management International Journal. For more information, in the Tax Management Portfolios, see Bissell, 907 T.M., U.S. Income Taxation of Nonresident Alien Individuals, Katz, Plambeck, and Ring, 908 T.M., U.S. Income Taxation of Foreign Corporations, and Stoffregan, Harris, and Wirtz, 910 T.M., Partners and Partnerships - International Tax Aspects, and in Tax Practice Series, see ¶7130, Foreign Persons - Effectively Connected Income.
1 Department of the Treasury, General Explanations of the Administration's Fiscal Year 2013 Revenue Proposals, at 96 (Feb. 2012), discussed in Blanchard, "Rev. Rul. 91-32 May Be Granted Authority - 20-Plus Years Late," 41 Tax Mgmt. Int'l J. 237 (5/11/12). The provision is also included in the president's 2014 fiscal year budget. See Department of the Treasury, General Explanations of the Administration's Fiscal Year 2014 Revenue Proposals, at 57 (Apr. 2012)
4 Where the partnership owns U.S. real property, FIRPTA tax withholding may apply under the authority of §§897(g) and 1445(e)(5). See Regs. §§1.897-7T and 1.1445-11T(b). The very existence of these specific rules, of course, calls into question the validity of Rev. Rul. 91-32.
5 The IRS could be, and has been, given authority to override the entity rule of §741 in certain parts of the Code. Ironically, one of those places is in the installment sales rules, which were implicated in the FAA. See §453A(e)(2). However, the grant of authority in that section of the Code does not extend to the ECI rules in §864. In any case, that grant of authority has never been exercised, and the FAA did not mention it.
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