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By Philip D. Morrison, Esq.
Deloitte Tax LLP, Washington, DC
As part of the Obama Administration's FY 2013 budget,1 it is proposed that Rev. Rul. 91-322 be codified. That revenue ruling holds that gain or loss of a nonresident alien individual or a foreign corporation from the sale or exchange of a partnership interest is effectively connected with the conduct of a U.S. trade or business to the extent of such partner's distributive share of unrealized gain or loss of the partnership that is attributable to property used or held for use in the partnership's trade or business in the United States. In other words, Rev. Rul. 91-32 applies an "aggregate" approach in taxing capital gains of foreigners from the sale of partnership interests.
In addition, this proposal would be enforced, in part, by the enactment of a new requirement that the transferee of a partnership interest withhold 10% of the amount realized by the transferor if the transferor failed to certify that it was not foreign. If the transferee fails to withhold the correct amount, the partnership itself would be liable for the amount of underwithholding.3
Given the lack of traction on the Hill that the past several years' worth of "Greenbook" international tax proposals have had, many readers will wonder why they should care much about this particular proposal. There are at least two reasons. First, as my lobbyist friends tell me, revenue-raising ideas without a strong, adverse constituency never die. They are always there as "pay-fors" for popular revenue expenditure ideas and are also possible additions to anyone's general international tax reform plan. Second, a proposal such as this one may allow, though not necessarily correctly, an inference to be drawn that the IRS and/or Treasury thinks Rev. Rul. 91-32 is technically flawed-i.e., that the rule being "clarified" is, in fact, being changed. Whether a court would agree with such a claim is far from clear, but not outside the realm of possibility. It is worthwhile, therefore, to examine this proposal.
The "Reasons for Change" section of the Treasury Greenbook for this proposal is fairly short: Nonresident alien individuals and foreign corporations may take a position contrary to the holding of Revenue Ruling 91-32, arguing that gain from the sale of a partnership interest is not subject to federal income taxation because no Code provision explicitly provides that gain from the sale or exchange of a partnership interest by a nonresident alien individual or foreign corporation is treated as ECI [effectively connected income]. If the partnership has in effect an election under section 754, the partnership's basis in its assets is also increased, thereby preventing that gain from being taxed in the future.4
There is no further explanation as to why, as a policy matter, such taxpayers' arguments should be rejected. Presumably, the Administration thinks that a foreign investor in a U.S. partnership should be treated differently than foreign investors in U.S. corporations. The former should be taxed on inside gain on the sale of an interest in the entity while the latter should not. The Administration apparently believes this is a proper policy answer whether or not there is a §754 election in effect because, in those cases where there is such an election, the inside gain would be free from (eventual) U.S. taxation.
Nor, at the moment, is there any discussion regarding the technical arguments as to whether or not Rev. Rul. 91-32 is a correct statement of current law. Indeed, many taxpayers take a position contrary to Rev. Rul. 91-32, not simply because "no Code provision explicitly provides that gain from the sale or exchange of a partnership interest by a nonresident alien individual or foreign corporation is treated as ECI" but because there are multiple arguments that the revenue ruling is wrong. Presumably, any legislative history will state that "no inference is intended" that this statutory change is anything other than a "clarification" of current law. The Greenbook makes no such statement, however, which may lead some to argue that Treasury is still considering this issue. And regardless of what the legislative history says, there always is an inference to be drawn from the codification of a prior IRS position.
Rev. Rul. 91-32, while not very clearly written, is based on a rationale that goes something like this: Entity or aggregate depends on which characterization is more appropriate to carry out the intent and/or purpose of the particular Code section under consideration. Brown Group5 is one of the more recent clear statements of this, but it's in earlier cases, too. Section 875 is the "closest" Code section regarding where to turn for intent/purpose guidance in deciding this issue. Section 875 makes the trade or business of the partnership the trade or business of the partners. Unger6 (and Donroy7 before it) expand this concept to make a permanent establishment (PE) and/or an office of a partnership the PE and/or office of the partners. The Ninth Circuit in Donroy does this because, as a matter of California state partnership law, the partners have an undivided interest in the assets, including the office, of the partnership. The Tax Court in Unger bases its identical conclusion on Donroy as well as a general review of Subchapter K, stating, "We hold a partner in a limited partnership owns an undivided interest in the assets of the partnership so that the partner has a PE in the United States if the partnership has a PE in this country." Rev. Rul. 91-32 takes this a step further in concluding that the sale of a partnership interest is, for ECI analysis purposes, the sale of that undivided interest in partnership property. To the extent the partnership property constitutes ECI assets, the partnership interest is ECI property. Because the sale of directly owned ECI assets would give rise to ECI, the sale of an undivided interest in such assets (via the sale of a partnership interest) also gives rise to ECI. Section 741 is irrelevant because all it tells us is whether gain is capital or ordinary. Section 897(g) was necessary to reach FIRPTA partnership investors where the partnership was not otherwise engaged in a U.S. trade or business.
The opposing argument I like the best goes something like this: Entity or aggregate depends on which characterization is more appropriate to carry out the intent and/or purpose of the particular Code section under consideration. Brown Group is one of the more recent clear statements of this, but it's in earlier cases, too. Section 741 is the "closest" Code section regarding where to turn for intent/purpose guidance in deciding this issue.
Section 741 declares that gain or loss on the sale of a partnership interest is gain or loss from the sale of a capital asset. The legislative history makes fairly clear that §741 is a codification of the case law disagreeing with the IRS's early view that the sale of a partnership interest is a sale of an undivided interest in the underlying partnership assets. Cases like PDB Sports8 hold that §741 trumps things like §1056 (which limits the amount a buyer can allocate to player contracts when a sports team is sold)-a sale of a partnership interest is separate from the sale of the underlying partnership assets. Unger can be distinguished (this argument goes) because §875 and its extension in Unger and Donroy deal with the taxation of the partnership's income and gain in the hands of the partners, not with the taxation of the disposition of a partnership interest. They don't, therefore, conflict with §741. Where there is a question regarding the taxation of the partnership interest, §741 takes precedence.
While a revenue ruling generally is accorded, at best, modest weight by courts, in a case where regulations are silent or where the IRS appears to be implementing Congress's mandate in a reasonable manner in a close case, courts sometimes give a revenue ruling more weight as seen in Industrial Valley Bank9 or Gino.10 This might be just such a close case because neither §741 (or the regulations or cases under it) nor §875 (or the regulations or cases under it) clearly address this issue. Therefore, if a court thought the question close, it might give some deference to the rationale of Rev. Rul. 91-32.
Now, however, the Administration has proposed that Rev. Rul. 91-32 be codified and enforced, at least in part, via a withholding obligation of the partnership interest purchaser and/or the partnership. If a court were to conclude that this indicates any governmental reservations about the technical correctness of that ruling, perhaps such a court would conclude that the ruling ought not to be given any deference. In that case, it is possible, while the proposal is pending but unenacted, that some courts might decide an application of Rev. Rul. 91-32 differently than they would have in the absence of this legislative proposal.
Finally, while the policy for the proposed rule may be supportable, at least where §754 elections are in effect, the adoption of a FIRPTA-like withholding regime in the partnership context would create several administrative difficulties for taxpayers and the IRS. First, it is unclear how the transferor would obtain the information required to compute its tax liability since gain or loss "attributable to" ECI property is a partnership-level determination.
Presumably, this would require a valuation of all of the partnership's assets on the date of any partner's transfer of a partnership interest. Second, there could be overwithholding in many circumstances, which would either require the processing of withholding certificates or refund claims by the IRS. Obtaining a withholding certificate from the IRS to reduce withholding would presumably require the partnership to produce a detailed computation of the unrealized gain or loss in each of its assets, which may not be possible prior to the transfer in many cases. FIRPTA has similar issues in the partnership context that create significant uncertainty for taxpayers and with respect to which regulations have never been issued. Like many ideas in international tax, this one may have some theoretical justification but, if enacted, could turn out to be unadministrable.
This commentary also will appear in the March 2012 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 Office of Management and Budget, 2013. Budget of the United States Government, Fiscal Year 2013. Office of Management and Budget, Washington, DC.
2 1991-1 C.B. 107.
3 The "Greenbook" states that the partnership "would satisfy the withholding obligation by withholding on future distributions that otherwise would have gone to the transferee."
4 Greenbook at 96.
5 Brown Group, Inc. v. Comr., 77 F.3d 217 (8th Cir. 1996).
6 Unger v. Comr., 936 F.2d 1316 (D.C. Cir. 1991).
7 Donroy Ltd. v. U.S., 301 F.2d 200 (9th Cir. 1962).
8 P.D.B. Sports v. Comr., 109 T.C. 423 (1997).
9 Industrial Valley Bank & Trust Co. v. Comr., 66 T.C. 272 (1976).
10 Gino v. Comr., 538 F.2d 833 (9th Cir. 1976).
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