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By Kimberly S. Blanchard, Esq.
Weil, Gotshal & Manges LLP, New York, NY
Back in 1997, I wrote a longish article questioning the authority for the IRS's conclusions in Rev. Rul. 91-32.1 It appears I may not have been quite as crazy as some people thought (or think). In this year's Green Book, the Administration has proposed to enact authority for the rule of Rev. Rul. 91-32.2 The reason for this proposal is worth printing in its succinct entirety:
In general, the sale or exchange of a partnership interest is treated as the sale or exchange of a capital asset. Capital gains of a nonresident alien individual or foreign corporation generally are subject to federal income tax only if the gains are or are treated as income that is effectively connected with the conduct of a trade or business in the United States (ECI). Section 875(1) provides that a nonresident alien individual or foreign corporation shall be considered as being engaged in a trade or business within the United States if the partnership of which such individual or corporation is a member is so engaged. Revenue Ruling 91-32 holds that gain or loss of a nonresident alien individual or foreign corporation from the sale or exchange of a partnership interest is effectively connected with the conduct of a trade or business in the United States to the extent of the 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 within the United States (ECI property). A partnership may elect under section 754 to adjust the basis of its assets upon the transfer of an interest in the partnership to reflect the transferee partner's basis in the partnership interest.
Reasons for Change
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. 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.
The Green Book explanation of why we need this now is misleading in at least two respects. First, §875(1) has nothing to do with characterizing the sale of a partnership interest. All it does is tell us that the character of partnership income passes through to its partners. It is a distributive share rule, not an outside gain rule.3
Second, foreign sellers do not simply "take the position" that they are not taxed on the gain from the sale of partnership interests based on the lack of any Code section imposing the tax. If they take that position, it is because there is a Code section directly on point, and favorable to them. Section 741 characterizes gain from the sale of a partnership interest as gain from the sale of a separate capital asset. It is an entity, not an aggregate, rule, and has been repeatedly upheld against challenges by those who would prefer it otherwise.4 Few if any rules in the Code are this clear. A partner has a basis and holding period for his partnership interest that is separate and distinct from the partnership's basis and holding period. This has been settled law for over 50 years.
In fact, §741 is so impermeable, Congress had to enact the "hot asset" rules in §751 in order to tax certain gains attributable to a partnership's unrealized receivables and inventory as ordinary income. Section 751 does not operate as an aggregate rule, because §741 stands in the way. Instead, §751 simply deems a portion of a selling partner's gain to be ordinary.
For the same reason, Congress had to write a special rule, §897(g), to cover the sale of partnership interests under the Foreign Investment in Real Property Tax Act (FIRPTA), which applies where the partnership owns one or more United States real property interests (USRPIs). The new legislative proposal to codify Rev. Rul. 91-32 is essentially identical to §897(g), except that it applies across the board, and not just to partnerships that own USRPIs.
Well! There is a reason that we do not have any regulations or guidance under §897(g) even though it has been around since 1980. Applying an aggregate, look-through rule to a simple partnership with two or three partners, one or two assets, and straight-up allocations is simple, but many partnerships have hundreds of partners and an infinite variety of asset types that are not necessarily valued every time a partner decides to sell a partnership interest. This is why withholding under §897(g) has never been applied outside of the case of a "real estate rich" partnership.6
So how would this new "super Rev. Rul. 91-32" legislation work? Here is what the Green Book says:Proposal
The proposal would provide that gain or loss from the sale or exchange of a partnership interest is effectively connected with the conduct of a trade or business in the United States to the extent attributable to the transferor partner's distributive share of the partnership's unrealized gain or loss that is attributable to ECI property. The Secretary would be granted authority to specify the extent to which a distribution from the partnership is treated as a sale or exchange of an interest in the partnership and to coordinate the new provision with the nonrecognition provisions of the Code.
In addition, the transferee of a partnership interest would be required to withhold 10 percent of the amount realized on the sale or exchange of a partnership interest unless the transferor certified that the transferor was not a nonresident alien individual or foreign corporation. If a transferor provided a certificate from the IRS that established that the transferor's federal income tax liability with respect to the transfer was less than 10 percent of the amount realized, the transferee would withhold such lesser amount. If the transferee failed to withhold the correct amount, the partnership would be liable for the amount of underwithholding, and would satisfy the withholding obligation by withholding on future distributions that otherwise would have gone to the transferee partner.
The proposal would be effective for sales or exchanges after December 31, 2012.
This proposal is simply breathtaking in its complexity and effect. It raises at least three serious conceptual problems: (1) How do the parties determine what portion of the seller's gain is "attributable" to a U.S. trade or business? (2) How are the assets so attributed valued? (3) How would a distribution by the partnership, which is already subject to aggregate treatment under §731, be handled?
The "attributable" inquiry is really two separate problems. First, one would need to know how to determine which assets of the partnership would give rise to ECI if sold directly by the partner. Second, one would need a rule prescribing how to net - or not - gains and losses from the deemed sale of each of those assets. Rev. Rul. 91-32 itself attempted to set out rules for calculating the ECI on a sale of a partnership interest and, even though it used only a very simple fact pattern, it failed to articulate a consistent approach to netting.7
The valuation problem will in many cases be insurmountable absent some fairly arbitrary assumptions being made. It is one thing to value the assets of an entire business being sold, such as is routinely done under §754 or §338. It is quite another thing to ask a partnership to undertake a wholesale valuation of its assets where a 00.1% partner sells an interest in the partnership and there is no third-party arm's-length bargaining over the asset allocation for the business as a whole. And this assumes that the partnership is even aware of the sale!
The above passage from the Green Book states that the IRS would be given authority to write rules treating a distribution by a partnership as a sale or exchange for this purpose. The Administration probably had at least two things in mind here. First, there may be an analogy to the hot assets rules at §751(b), which attempt to prevent partners from shifting built-in ordinary income items between themselves using distributions. Second, the Administration may have had in mind a rule similar to the rule in §897(h)(1), which applies when a REIT distributes the proceeds of a sale of a USRPI. In Notice 2007-55,8 the IRS concluded that §897(h)(1) applies to liquidating, as well as ordinary, distributions, even though liquidating distributions are normally treated as the disposition of REIT stock and not a share of the REIT's assets. Both sets of rules are extraordinarily complex to apply.
Yet by far the most stunning aspect of this new proposal is the requirement that the buyer of the partnership interest withhold. I forget which tax lawyer started the story about the two goat herders in Mongolia, but it is apt here. If one Mongolian goat herder sells a 0.01% partnership interest in, say, a Chinese partnership doing business in the United States to another Mongolian goat herder, do we seriously expect the second to withhold and pay over U.S. tax on the portion of the former's gain attributable to those U.S. trade or business assets? The Administration proposal seems to recognize the problem, stating that if the tax is not withheld by the buyer, the partnership itself is made liable for the tax. But this goes even further than the FIRPTA statute and regulations, which at least have a clear U.S. nexus in the form of immovable real property located in the United States. The proposal essentially operates like laws in India, Mexico and other countries that make a corporation liable for the tax required to be withheld by a buyer on the sale by a nonresident of stock in a resident corporation. It assumes that the object of the sale - the entity whose stock or equity interests are sold - is aware of the sale and can monitor the parties' compliance with purely extraterritorial withholding tax rules.
The Green Book proposal is stated to be effective after December 31, 2012. This might be interpreted as an admission that Rev. Rul. 91-32 is currently a dead letter. One might wonder whether the few foreign sellers of partnership interests who paid tax under the authority of the revenue ruling should now seek refunds on the basis that there was no authority to impose the tax.
This author is sympathetic to the problem presented by a tax-free sale of a partnership interest with a step-up to the buyer. But it is important to keep in mind that this problem is not limited to foreign sellers. A sale by a U.S. tax-exempt organization presents exactly the same problem - actually, a worse problem, as the U.S. tax-exempt does not even pay tax at home - yet U.S. tax-exempts are nowhere mentioned in the Green Book proposal.9 And it is also important to keep some perspective on the problem: Very few foreign persons or U.S. tax-exempt persons directly own interests in operating partnerships, because they are subject to tax, to branch tax (in the case of foreign corporate partners), and to reporting. In almost all cases, the foreign or exempt person will invest in a partnership only through a U.S. corporation subject to tax on its worldwide income (a so-called "blocker"). So the number of Mongolian goat herders we need to worry about is probably really small.
If the Administration nevertheless believes this is a problem that needs solving, a much simpler solution would be to deny the §754 step-up to the buyer unless the seller certifies it has paid tax on its ECI or UBTI. Whatever solution may ultimately be adopted, it would seem that it must apply to U.S. tax-exempt organizations as well as to foreign persons. Any contrary approach would be at grave risk of violating the United States' nondiscrimination agreements with foreign countries.10
This commentary also will appear in the May 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, Stoffregan, Harris, and Wirtz, 910 T.M., Partners and Partnerships - International Tax, and in Tax Practice Series, see ¶7130, Foreign Persons - Effectively Connected Income.
1 1991-1 C.B. 107. See Blanchard, "Rev. Rul. 91-32: Extrastatutory Attribution of Partnership Activities to Partners," 76 Tax Notes 1331 (9/8/97).
2 Dept. of the Treasury, General Explanations of the Administration's Fiscal Year 2013 Revenue Proposals, at 96 (Feb. 2012).
3 Section 512(c)(1) performs the same role for tax-exempt partners of partnerships and, like §875, is only a distributive share rule. This comparison is discussed more later in the text.
4 See, e.g.,Pollack v. Comr., 69 T.C. 142 (1977).
6 Regs. §1.1445-11T.
7 The revenue ruling states that net gain or loss is computed separately for ECI and non-ECI assets, but this formulation is not helpful, since separate computation is not inconsistent with aggregation of the resulting components. The language used appears to suggest that the selling partner cannot net non-ECI losses against ECI gains. But presumably the selling partner cannot be taxed on more than his actual gain.
8 2007-27 I.R.B. 13.
9 As noted in my 1997 article, the House at one point proposed to subject sales of partnership interests by tax-exempt partners to tax on exactly this theory. The bill was, of course, never enacted.
10 This is why, of course, §163(j) applies to U.S. tax-exempts as well as to foreign persons.
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