Grecian Magnesite Mining: Impact on Investments by Non-US Investors in US Funds
US Tax Court decision may facilitate tax-efficient investment structures for non-US investors investing in US operating partnerships, directly or through investment funds.
On July 13, the US Tax Court issued a taxpayer-favorable decision in Grecian Magnesite Mining, Industrial & Shipping Co., SA v. Commissioner,  concluding that a non-US partner is not subject to US tax on gain from the sale of a partnership interest in a partnership conducting business in the United States. The decision rejects the conclusion of a 26-year-old IRS ruling, Revenue Ruling 91-32.
This decision has implications for the manner in which non-US investors invest in US operating partnerships, either directly or through investment funds, and could present tax refund opportunities for certain non-US investors that previously paid tax on gains from sales of interests in US operating partnerships.
Revenue Ruling 91-32 reflects the IRS position that a non-US investor selling an interest in an entity that is classified as a partnership for US federal tax purposes will be treated as realizing income that is effectively connected with a US trade or business (ECI) to the extent the gain on the sale of the interest is attributable to a US trade or business of the partnership operated through a fixed place of business. In that situation, rather than characterizing gain from the sale of the partnership interest as non-US-source gain from the sale of property (which is generally not subject to US federal income tax), the 1991 ruling treats the non-US investor’s gain on a sale of the partnership interest as ECI to the extent attributable to the partnership’s assets that would generate ECI if sold by the partnership. Accordingly, the ruling characterizes any such gain as ECI to the extent such gain is attributable to the non-US investor’s share of the partnership’s property used to generate ECI.
ECI is taxable at graduated US federal income tax rates on a net basis (up to 39.6% for non-corporate persons, and up to 35% plus a potential 30% branch profits tax for corporations) and is subject to reporting on a US federal income tax return. Based on this position, and because a partnership’s allocations of ECI generated in its normal operations to non-US investors are treated as ECI in the hands of such investors, non-US investors sensitive to the receipt of ECI have generally sought to structure investments in ECI-generating US funds by utilizing techniques that often involve the use of corporate entities known as “blockers” to avoid direct receipt of ECI and the related tax consequences, including the obligation to file US federal income tax returns.
Grecian Magnesite Mining
Grecian Magnesite Mining involved a Greek mining corporation (hereinafter, “Grecian”) that was a member of a Delaware LLC that was classified as a partnership for US tax purposes (the “LLC”). Grecian otherwise had no direct presence in the United States in terms of office space or personnel. The LLC itself was engaged in a US trade or business, with active mining operations in Florida, Nevada, and Pennsylvania. The LLC also owned US real property. In 2008, Grecian elected to have its 12.6% interest in the LLC redeemed for $10.6 million. On audit, the IRS identified a deficiency in the income reported by Grecian of approximately $6.2 million in relation to the redemption of the LLC interest, asserting that the gain from the redemption proceeds was ECI rather than non-US-source gain from the sale of property. Of this amount, Grecian accepted that $2.2 million was properly treated as gain attributable to the LLC’s US real property interests (and thus treated as ECI under the “look-through rule” found in section 897(g) of the Internal Revenue Code). Grecian, however, contested the treatment of the remaining $4 million of gain (the “disputed amount”) as ECI. The case eventually landed in the US Tax Court, where the court rejected Revenue Ruling 91-32 and the IRS’s arguments that Grecian should have been subject to tax on the disputed amount.
The court’s decision articulates its view that interests in a partnership are generally treated as equity interests in an entity, and as an asset that is separate and distinct from the assets held by the partnership (subject to express exceptions in the Internal Revenue Code to such treatment, such as with respect to US real property interests). In the context of Grecian Magnesite Mining, the court held that the disputed amount was properly treated as gain derived from a non-US source (due to Grecian’s non-US residence and the absence of any role of the LLC’s US office in the redemption transaction) and not as gain attributable to a US trade or business that would be treated as ECI subject to US federal income tax. The court expressly disagreed with Revenue Ruling 91-32 and rejected the IRS’s arguments on the grounds that the Internal Revenue Code mandated treatment of Grecian’s gain as having been derived from the disposition of a single asset (the LLC interest) rather than from Grecian’s interest, through the LLC, in the LLC’s assets.
Impact and Caution
Grecian Magnesite Mining is a favorable decision for non-US investors because it could significantly reduce the overall ECI tax burden on non-US investors that hold equity interests directly or indirectly through other pass-through entities, including US funds, in US operating partnerships, without using a corporate blocker structure.
However, the US Tax Court’s decision does not alter the consequences for non-US investors that receive allocations of ECI from a partnership as a result of income from underlying operations. As a result, under the court’s decision, non-US investors holding equity interests in entities that are classified as partnerships for US federal tax purposes could still receive allocations of ECI and have related tax return filing and payment obligations. Still, fund managers and non-US investors may want to evaluate the manner in which corporate blockers are used in the context of investments in investment funds, or investments by funds in underlying partnerships, that may generate relatively small amounts of ECI from ongoing operations if the interests in those funds or underlying operating partnerships are expected to be sold for significant gains.
Of course, because the Grecian Magnesite Mining decision squarely rejects a relatively longstanding IRS position (the effect of which raises revenue), appeals are possible, and regulatory or US congressional action also could be taken to overturn the court’s decision.  Although appeals or regulatory or congressional action may end up nullifying the court’s decision, taxpayers that have paid tax on ECI from a sale or redemption of an interest in an entity classified as a partnership for US federal tax purposes in open tax years should consider filing refund claims to preserve the right to a refund of such taxes (subject to possible challenge by the IRS in the Court of Federal Claims) in the event that the US Tax Court’s decision in Grecian Magnesite Mining is not appealed or is sustained on appeal.
 1991-1 C.B. 107.
 The Obama administration had previously proposed the codification of Revenue Ruling 91-32.