Sale of U.S. partnership interest by a foreign person.

As the sale of a U.S. partnership interest by a foreign entity or person raises classic entity versus aggregate issues. This classification is critical because it can determine the source of the income; this, in turn, affects whether the gain is subject to U.S. income tax. This item examines the possibility that a reasonable position exists for a "middle of the road" approach between the entity and aggregate theories.

The IRS's View

Despite the fact that Subchapter K primarily adopts an entity approach to partnership taxation for the sale of partnership interests, Rev. Rul. 91-32 nonetheless applies the aggregate theory, concluding that (1) gain from the sale of a partnership interest was sourced to the U.S. because it was "attributable" to a foreign partner's fixed place of business in the U.S.; and (2) such gain was effectively connected income (ECI) under the Sec. 864(c)(2) "asset use test" because the value of the partnership's business activity affected that of the partnership interest.

In Rev. Rul. 91-32, the IRS's reasoning appears inconsistent in the application of the U.S. sourcing, ECI and partnership provisions. The Service cites Unger, 936 F2d 1316 (DC Cir. 1991), in which the business profits of a partnership with a U.S. permanent establishment were attributed to a foreign partner, in concluding that gain from the sale of the foreign partner's partnership interest is U.S.-source income.

Unlike Unger, the gain in Rev. Rul. 91-32 is from the sale of the partnership interest, not the partnership's business profits. The Service asserts that "[i]ncome from the disposition of a partnership interest by the foreign partner will be attributable to the foreign partner's fixed place of business" in the U.S., but does not provide any analysis to support this view beyond citing Unger and Sec. 865(e)(3) (which refers to Sec. 864(c)(5) in determining whether a sale of personal property is attributable to a U.S. fixed place of business). Under the Sec. 864(c)(5) attribution rules, gain is not attributable to a U.S. office unless the office is a material factor in the production of income and regularly carries on activities of the type from which the gain is derived. Thus, the disposition of the partnership interest should not be attributable to a U.S. office under Sec. 864(c)(5), assuming the partnership does not regularly sell partnership interests.

The IRS then applied the Sec. 864(c)(2) asset test to determine whether the U.S.-source gain is ECI. However, the Service failed to consider whether the property was held (1) to promote the business, (2) in the ordinary course of the business or (3) in a direct relationship to the partnership's trade or business, as required by Regs. Sec. 1.864-4(c)(2)(ii). Instead, it merely noted that the value of the partnership's business activities affects the value of the foreign partner's partnership interest and that the interest is an asset used by the foreign partner in his U.S. trade or business.

Is Rev. Rul. 91-32 Correct?

Although the Service's conclusions in Rev. Rul. 91-32 may appear sound from a policy perspective, this ruling has caused some controversy due to a lack of authority for its conclusions.

Sec. 741 explicitly applies an entity approach to the sale of a partnership interest. In situations in which Congress did not want entity theory used, it created specific exceptions to Sec. 741 (e.g., the Sec. 751 "hot asset" rule and the Foreign Investment in Real PropertyTax Act of 1980 (FIRPTA) provisions of Sec. 897(g)).Thus, it appears that the Sec. 741 entity theory, rather than the aggregate theory the IRS set forth in Rev. Rul. 91-32, should govern such sales, in the absence of specific Congressional guidance.

When considering the Service's inconsistent application in Rev. Rul. 91-32 of the relevant Code provisions, it appears reasonable to conclude that Sec. 741 provides substantial authority for not reporting a nonresident individual's sale of an interest in a U.S. partnership as U.S.-source income (i.e., in the absence of Sec. 751 hot assets). Essentially, applying the rationale of Rev. Rul. 91-32 would subject to U.S. taxation the entire gain of a foreign partner disposing of an interest in a partnership having only U.S. activities. By contrast, applying the Sec. 741 provisions would generally result in the capital gain escaping U.S. taxation, except to the extent of Sec. 751 assets and FIRPTA property.

Other Issues

When a foreign partner disposes of a partnership interest, the application of Sec. 751 rules in the context of the international tax provisions on sourcing and ECI must be considered. An assessment of the FIRPTA implications (if any) is also essential. Under the FIRPTA, a foreign person's gain on the disposition of any "U.S. real property interest" as specifically defined, is ECI subject to U.S. taxation at graduated tax rates. Further, the potential branch--profits tax implications associated with the disposition of a U.S. partnership interest by a foreign person must be analyzed. Finally, the applicable treaty provisions and check-the-box planning should be examined.

Conclusion

Obviously, a foreign partner's disposition of a partnership interest is much more complex than it may initially appear. Fortunately, with proper tax planning, opportunities may arise to minimize the potentially adverse U.S. tax consequences associated with the numerous provisions mentioned above.

FROM ALLISON M. MCSWEENEY, CPA, AND ROBERT C. PEDERSEN, CPA, J.D., LL.M., NEW YORK, NY