By Carrie Koshkin, Director, Moore Stephens Doeren Mayhew

In a July 2017 Tax Court case, the ruling determined for a foreign corporation that was a partner in a U.S. partnership and redeemed the foreign corporation’s interest in the U.S. partnership, was that a portion of the capital gain was not taxable for U.S. purposes. This decision went against an Internal Revenue Service (IRS) ruling that has been around for 25 years, and the court was even harsh in its criticism of the ruling’s analysis of the foreign provisions of the code by stating, “We decline to defer to the ruling (Rev. Rul. 91-32).”

The case is also interesting because it addressed the issue of penalties for failure to file and failure to pay, and what might constitute reasonable cause as a defense against them. Reliance, especially by a foreign taxpayer, on a U.S. attorney and CPA who advised the foreign taxpayer it was not subject to U.S. tax and did not need to file a Form 1120-F was considered to be reasonable cause related to the portion of the capital gain that was subject to U.S. tax because it was related to real estate owned by the U.S. partnership – Foreign Investment in Real Property Tax Act of 1980 (FIRPTA) provisions.

Grecian Magnesite Mining, Industrial & Shipping Co., SA (GMM) v. Commissioner

The Tax Court case involved a Greek corporation that invested in a U.S. partnership that is in the business of extracting, producing and distributing magnesite, which it mined or extracted from mines in the United States. This was similar to the business that GMM was involved with in Greece. However, GMM never had its own office, employees or business operations in the United States. GMM made an initial capital contribution, for which it received a 15 percent interest in the Limited Liability Company (LLC) that was treated as a partnership for U.S. tax purposes.

After more than seven years of ownership in the LLC, GMM entered into an agreement for the LCC to redeem its interest. The redemption was to be completed in two transactions, which occurred over two taxable years. GMM did not initially pay any tax related to the capital gain and did not file a Form 1120-F for the year the second distribution was made since it was not a member of the LLC for that year and did not have any U.S.-source Effectively Connect Income (ECI). However, due to the real estate owned by the LLC, FIRPTA provisions applied and GMM ultimately conceded it owed U.S. tax on the gain related to the real estate.

The partnership area has always had the two, sometimes conflicting, concepts of “aggregate” versus “entity” approach. Because a partnership has its income flow through to its partners, there are situations under tax law where each partner looks to their share of the underlying activity of the partnership, and the type and source of the income and expenses are determined at the partner level.

The entity concept, on the other hand, looks at the partnership as a separate legal entity owned by the partner and issues are determined at the partnership level. This is where the outside basis of the partnership interest held by the partners may be different than the basis of the assets and liabilities held inside the partnership. The IRS (and the position espoused by Rev. Rul. 91-32) tried to take the aggregate approach and treat the redemption (or a sale) as a sale of each of the underlying assets held by the partnership rather than as a sale of a partnership interest. The Tax Court acknowledged the two concepts, but stated that in this situation, because of Sec. 741, this was an entity issue and decided the taxpayer was not subject to U.S. taxation.

Reasonable Cause Issue

Because GMM did not initially file a return or pay any tax on the capital gain, including on the FIRPTA-related gain, the IRS assessed penalties for failure to file and failure to pay the tax. GMM finally conceded it owed tax related to the gain from the real estate held by the partnership, but claimed it had reasonable cause because it had relied on its CPA, who had advised they did not owe any tax and did not have to file. Reasonable cause has always been a very fact and circumstance issue that has often been difficult to overcome in arguments with the IRS.

Reasonable cause must also involve a showing that there was not willful neglect. Ignorance of the rules is normally not a defense, especially where no action was taken to determine the correct tax impact of a transaction.

There are three requirements for a taxpayer to use reliance on a tax professional to avoid a penalty as addressed in this case:

  1. The adviser was a competent professional who had sufficient expertise to justify reliance
  2. The taxpayer provided necessary and accurate information to the adviser
  3. The taxpayer actually relied in good faith on the adviser’s judgment

The IRS conceded the second requirement, but not the others, claiming the taxpayer should have hired someone with international tax expertise. The Court responded, “Given what little GMM knew about the U.S. system of taxation, we cannot imagine GMM would have known how to conduct such an investigation, let alone what value such uninformed inquires would have added. GMM acted reasonably, given its admitted inexperience and relied on the recommendation of its trusted adviser, Mr. Phufas, when it chose to hire Mr. Rose.”

Apparently, the attorney and CPA, Mr. Rose, who had been preparing tax returns for 40 years, spent 30 percent to 40 percent of his time preparing income tax returns for a wide variety of clients. Therefore, the Court felt there was reasonable cause in this situation.

Refund Claims Possible

A number of tax practitioners have questioned the validity of Rev. Rul. 91-32, and the IRS position that a foreign partner of a U.S. partnership had to pay U.S. tax on the sale or redemption of its partnership interest, especially where the foreign partner was not involved in the affairs of the U.S. partnership. Before now, no one had challenged this position in court. While the case is appealable by the IRS, it appears that it will be difficult for the IRS to overcome the reasoning of the court in this case. Also, the IRS could non-acquiesce in the case.

There may be a refund opportunity for foreign partners who have paid U.S. tax on sales of U.S. partnerships if the statute of limitation is still open. The international tax advisors at Moore Stephens Doeren Mayhew are available to discuss the facts that would allow for the filing of a refund claim in these situations as well as assist with structuring investments into the US for investors. For more information, contact us today.

This blog post is a reprint from Moore Stephens Doeren Mayhew’s GlobalVIEW.