A Major Tax Court Decision is a “Game-Changer” for Foreign Investment in U.S. BusinessesJuly 2017
In a victory for foreign investors, the U.S. Tax Court issued an opinion on July 13 that changes the tax planning landscape for foreign investment in the U.S. and creates new opportunities for foreign investors to increase their after-tax returns from U.S. businesses.
Since it was issued by the IRS in 1991, controversial Revenue Ruling 91-32 has guided the structuring of foreign investment in the U.S. Under the ruling, gains of a non-U.S. partner from the disposition of an interest in a partnership engaged in U.S. trade or business is income effectively connected with such U.S. trade or business (“ECI”). Practitioners have questioned the validity of this conclusion, arguing that it deviates from the general rule that gains from capital asset dispositions by non-U.S. persons are not subject to U.S. tax.
ECI of a non-U.S. person is typically subject to U.S. net income taxation at graduated rates and also, in the case of a foreign corporate taxpayer, to a 30% “branch profits tax.” In addition, a non-U.S. person that derives ECI is generally required to file U.S. income tax returns. These adverse tax consequences to non-U.S. investors have typically been avoided by interposing a U.S. corporation between the foreign investor and the partnership engaged in a U.S. trade or business. The U.S. corporation prevents the imposition of the branch profits tax and acts as a “blocker” to protect the foreign investor from U.S. income tax payment and return filing obligations. Unfortunately, one cost of employing a blocker structure is a significant exit toll, in the form of U.S. corporate income taxes imposed on the gains from the disposition of the U.S. partnership interest.
The Grecian Case
In its July 13 decision in Grecian Magnesite Mining, Industrial & Shipping Co., SA v. Commissioner, the Tax Court rejected the government’s position in Revenue Ruling 91-32 and held that gain realized by a foreign corporation on the redemption of its interest in a partnership is not subject to U.S. income tax, even though the partnership was engaged in a U.S. trade or business. This holding similarly should apply to the sale of an interest in a partnership by a foreign corporation or another non-U.S. person. Note that the Grecian decision does not apply to gain from the disposition of a partnership interest that is attributable to an interest in U.S. real property. Under applicable statutory rules, those gains will continue to be treated as ECI. Also, Grecian does not change the rule that the profits of the partnership itself that are ECI and that flow through to a non-U.S. partner are treated as ECI in the hands of such non-U.S. partner.
Grecian Provides Significant Tax Planning Opportunities for Foreign Investors, and U.S. Private Equity Funds with Foreign Investors
The government may appeal Grecian or may otherwise attempt to reverse the decision through a legislative action or a regulation. Barring any such reversal, the Tax Court’s decision opens the door to unprecedented tax planning opportunities for foreign investors, and U.S. private equity funds with foreign investors, to generate considerably more attractive after-tax returns from investments in U.S. businesses. The main goal of a successful tax planning strategy with respect to such investments is twofold: (i) to bypass the U.S. exit toll by relying on the holding in Grecian and, at the same time, (ii) to protect foreign investors from U.S. income tax payment and return filing obligations, and ensure that the 30% branch profits tax will not apply to U.S. business profits.
To date, conservative planning for foreign investment in the U.S. has typically been tailored to reflect the holding in Revenue Ruling 91-32. However, the taxpayer victory in Grecian provides a catalyst to consider more tax efficient alternatives. We suggest that foreign investors and private equity funds with such investors avail themselves of the opportunity afforded by Grecian and consider available strategies to maximize the tax efficiency of existing and future investments.
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 1991-1 C.B. 107.
 149 T.C. No. 3 (2017).
© 2017 Herrick, Feinstein LLP. This alert is provided by Herrick, Feinstein LLP to keep its clients and other interested parties informed of current legal developments that may affect or otherwise be of interest to them. The information is not intended as legal advice or legal opinion and should not be construed as such.