A U.S. Tax Court opinion could affect some Canadian businesses with U.S. interests.
In Grecian Magnesite Mining, Industrial & Shipping Co., SA v. CIR, the Court held that a non-U.S. partner's capital gain on the redemption of its interest in a U.S. partnership engaged in a U.S. trade or business was not subject to U.S. federal income tax. The U.S. Tax Court rejected the IRS's position in Rev. Rul. 91-32, where the IRS held that U.S. federal income tax should be paid on a non-U.S. partner's gain from a sale of an interest in a partnership engaged in a U.S. trade or business.
The IRS took a controversial position in a 1991 ruling when it took an "aggregate" approach and ruled that a gain recognized by a non-U.S. partner on the sale (or disposition) of its interest in a partnership engaged in a U.S. trade or business should be analyzed based on the partnership's underlying assets and activities (under the aggregate approach, the partner is generally viewed as owning its proportional interest in the partnership's assets and the partnership is not treated as a separate entity from the partners). Under this approach, the portion of the gain on the sale of the partnership interest that the IRS would treat as income effectively connected with a U.S. trade or business (and fully subject to U.S. tax at graduated rates) is based on the partner's pro-rata share of the gain that would be effectively connected income if the partnership were to sell all of its assets.
In this recent case, a non-U.S. company (ForeignCo) acquired an interest in a U.S. limited liability company (LLC) that conducted a trade or business in the United States. The U.S. LLC was a partnership for U.S. income tax purposes. ForeignCo otherwise had no office, employees or business operations in the United States. LLC redeemed ForeignCo's interest in the LLC (around 12.6 percent) and ForeignCo realized a capital gain of approximately $6.2 million. ForeignCo filed its U.S. tax return reporting its distributive share of partnership income, but did not report any of the gain on the redemption.
The IRS asserted that ForeignCo had a U.S.-source gain that was effectively connected with a U.S. trade or business, under the approach of Rev. Rul. 91-32.
The Tax Court found no statutory basis to find that the gain on the disposition of ForeignCo's U.S. LLC interest was taxable in the U.S. (with the exception of the gain attributable to the LLC's U.S. real property).
The Tax Court found that, with the exception of a portion of the gain attributable to the LLC's U.S. real property assets that was subject to U.S. tax under a specific rule (IRC section 897(g)), the gain ForeignCo realized on the redemption of its partnership interest was derived from the sale of a single capital asset (the partnership interest itself, not the pro rata portion of all of the partnership assets as described in Rev. Rul. 91-32).
The Tax Court specifically rejected the IRS' position in Rev. Rul. 91-32.
Following this conclusion, the Tax Court then analyzed whether the capital gain was U.S. source income and taxable in the hands of a non-U.S. partner as effectively connected income. The Tax Court determined, that ForeignCo's gain on its LLC interest was a non-U.S. source gain and not subject to U.S. tax. The Tax Court disagreed with the IRS that the gain was attributable to the U.S. LLC's office or other fixed place of business. The Tax Court based its conclusion on the fact that the U.S. LLC merely provided clerical functions in executing the actual redemption, and the LLC's ordinary business activities were related to production of magnesite, not issuing and redeeming partnership interests.
This case is not final and remains subject to appeal. Furthermore, the IRS could issue additional regulatory guidance that would have the effect of reversing the Tax Court decision. While the Tax Court case is potentially quite helpful, Canadian taxpayers should consult their U.S. tax adviser to determine the best course of action following this decision.
For more information, contact your KPMG adviser.
Information is current to July 25, 2017. The information contained in this publication is of a general nature and is not intended to address the circumstances of any particular individual or entity. Although we endeavour to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. No one should act upon such information without appropriate professional advice after a thorough examination of the particular situation. For more information, contact KPMG's National Tax Centre at 416.777.8500