A Tax Court ruling in July could pave the way on how overseas companies book profit from their business in the U.S. after finding that a foreign firm that bought a U.S. company doesn’t have to pay tax because the money was not deemed a foreign source income.
In 2001, Grecian Magnesite Mining (GMM), a corporation based in Greece, purchased an interest in Premier Chemicals, LLC (Premier), a U.S. limited liability company that was treated as a partnership for U.S. income tax purposes. From 2001 to 2008, income was allocated to GMM from Premier, and GMM paid income tax in the U.S.
In 2008, GMM's interest was redeemed by Premier, and GMM received two liquidating payments, one in July 2008 and the second in January 2009 but deemed to have been made on Dec. 31, 2008. GMM realized gain totaling more than $6.2 million, of which $2.2 million was deemed attributable to U.S. real property interests (which GMM conceded was taxable income).
GMM contends that the remainder — the “disputed gain” of $4 million — is not taxable for U.S. purposes.
GMM timely filed a Form 1120-F (U.S. Income Tax Return of a Foreign Corporation) for 2008, in which it reported its distributive share of Premier's income, gain, loss, deductions, and credits, but did not report any income it received from the redemption of its partnership interest (i.e., neither the now conceded real estate gain nor the disputed gain).
GMM did not file a return or pay any income tax in the U.S. for 2009. GMM's reporting position was recommended to it by an experienced certified public accountant (CPA) who was recommended to GMM by its U.S. lawyer.
The IRS prepared a substitute for return under Code Sec. 6020(b) for GMM's 2009 year and issued a notice of deficiency for 2008 and 2009, determining that GMM must recognize its gain on the redemption of its partnership interest for U.S. tax purposes as U.S.-source income that was effectively connected with a U.S. trade or business, consistent with Rev Rul 91-32.
GMM sought relief in the Tax Court.
GMM argued that the redemption of its interest in Premier was a one-time, extraordinary event and so was not undertaken in the ordinary course of Premier's business.
It also argued that Premier's U.S. office is in the business of selling and producing magnesite, not buying and selling partnership interests.
Because the disputed gain was realized in the redemption of GMM's partnership interest in Premier, not from Premier's ordinary business (production and sale of magnesite), it did not satisfy the ordinary course requirement and was not a U.S. source.
The definition of foreign source income is: “Income earned from investments made outside the domiciled country of the investing entity such as a mutual fund and that is typically taxed at the foreign source. In the U.S., foreign sourced income is also taxable to recipients although a foreign tax credit may be available for eligible taxpayers.”
IRS disagreed with GMM's characterization of Premier, and pointed to Premier's other actions — admitting a new partner and redeeming its interests — to show that Premier's redemption of GMM's interest was not an isolated event.
The IRS took the position that the wording of Code Sec. 865(e)(2)(A) (“any sale of personal property”) was broad enough to cover all sales of personal property, including occasional sales.
The Tax Court concluded that GMM's disputed gain was capital gain that was not U.S.-source income. It held that the disputed gain was not effectively connected with a U.S. trade or business.
The Tax Court declined to follow Rev Rul 91-32. Accordingly, GMM was not liable for U.S. income tax on the disputed gain. Rev Rul 91-32 held that the gain realized by a foreign partner upon disposing of its interest in a U.S. partnership should be analyzed asset by asset, and that, to the extent the assets of the partnership would give rise to effectively connected income if sold by the entity, the departing partner's pro rata share of such gain should be treated as effectively connected income.
In other words Rev Rul 91-32 essentially adopted a Code Sec 751 analysis for inventory and receivables.
However, the Tax Court found that Rev Rule 91-32, with its extremely cursory treatment of the partnership provisions, lacked the power to persuade.
GMM's case illustrates how you get out of foreign source income.
About Craig W. Smalley, EA
Craig W. Smalley, MST, EA, has been in practice for almost 23 years. He has been admitted to practice before the IRS as an enrolled agent and has a master's in taxation. He is well-versed in US tax law and US Tax Court cases. He specializes in taxation, entity structuring and restructuring, corporations, partnerships, and individual taxation, as well as representation before the IRS regarding negotiations, audits, and appeals. In his many years of practice, he has been exposed to a variety of businesses and has an excellent knowledge of most industries. He is the CEO and co-founder of CWSEAPA PLLC and Tax Crisis Center LLC; both business have locations in Florida, Delaware, and Nevada. Craig is the current Google small business accounting advisor for the Google Small Business Community. He is a contributor to AccountingWEB and Accounting Today, and has had 12 books published on various topics in taxation. His articles have also been featured in the Chicago Tribune, New York Times, Yahoo Finance, Nasdaq, and several other newspapers, periodicals, and magazines. He has been interviewed and been a featured guest on many radio shows and podcasts. Finally, he is the co-host of Tax Avoidance is Legal, which is a nationally broadcast weekly Internet radio show.