Tax Court Opens Door for Foreign Investment in Partnerships
The court recently reversed an IRS position in a move that should provide comfort to foreign LPs and may attract overseas investors to U.S. funds.
The abundance of businesses formed as partnerships, and the tax efficiency that they offer, make partnerships and limited liability companies welcome targets for investment funds.
However, foreign limited partners—which typically are subject to U.S. withholding tax only on U.S. source dividends and interest (but not capital gains)—are subject to U.S. tax on a net basis on the income earned by these partnerships. They must also file U.S. tax returns reporting on that income.
The Internal Revenue Service’s position since 1991 has been that foreign LPs are subject to U.S. taxation on the gain from the sale of such partnership interests. That was until last week, when the United States Tax Court overturned the IRS stance in a move that should provide substantial comfort to foreign limited partners. It may even attract overseas investors to U.S. funds that invest in partnerships.
Investment funds often set up vehicles through which foreign LPs can invest in portfolio companies with less tax exposure. Known as blocker corporations, these entities, rather than the foreign LPs, pay the U.S. tax on operating income. In certain cases, they may allow foreign LPs to avoid return-filing obligations. The strategy does not substantially increase the indirect tax burden on the foreign LPs with respect to their share of the operating income, compared with what they would have paid had the portfolio company been converted to a corporation.
U.S. blocker corporations are subject to tax on the gain from the sale of the underlying LP interest. The IRS position is that foreign blockers similarly are subject to tax on the gain on the sale of LP interests. This creates a significant disparity in the tax burden on foreign LPs—which generally are not subject to U.S. tax on their capital gains from the sale of corporate stock. It may dissuade foreign investors from committing to funds that invest substantially in U.S. partnerships and limited liability companies.
Case in Point: Grecian Magnesite
Tax practitioners generally believed that the IRS position was incorrect. However, take a situation where a foreign LP is invested in a fund that invests in partnerships and does not own its interest in the partnership portfolio company through a blocker. In this instance, the general partner of the fund may withhold tax on the gain from the sale of the partnership interest in order to avoid personal liability.
North Carolina-based Premier Magnesia LLC, for example, is taxed as a partnership and conducts operations through facilities within the United States. In 2008, the company, which makes magnesia-based products for agricultural, industrial and environmental markets, redeemed the membership interest of Grecian Magnesite Mining, Industrial & Shipping Co., SA, headquartered in Athens, Greece.
Grecian did not report any of its gain from the redemption of its interest in Premier, and it did not file a tax return.
On July 13, 2017, the U.S. Tax Court upheld Grecian’s position that the gain was a capital gain that was not U.S. source income and thus was not taxable in the United States. The court was critical of the government’s position in the IRS revenue ruling on which the government’s position was based, and in the case itself.
Grecian Magnesite does not change the statutory rule that gains attributable to U.S. real property interests held by partnerships are taxable. Nor does the general rule that income derived by a partnership—known as effectively connected income—will flow through to foreign partners and be taxable for them.
PE funds and foreign LPs will likely still consider investing in partnerships through blockers. But investing through foreign blocker corporations generally allows the blocker to avoid U.S. taxation on the sale of the partnership interest. Foreign investors that have paid the tax on the sale of a domestic partnership should consider filing claims for refund before the three-year statute of limitation for such claims expires.