30 July 2024 US Court of Appeals holds that a nonresident's gain from the sale of its US partnership interest attributable to inventory is not US-source income, reversing an earlier Tax Court decision
In Rawat v. Commissioner, No. 23-1142 (D.C. Cir. July 23, 2024) (Rawat), the US Court of Appeals for the DC Circuit (Court of Appeals) reversed a Tax Court decision (T.C. Memo 2023-14) that sourced inventory gain arising from the sale of a US partnership interest as though the taxpayer had actually sold the inventory that gave rise to the gain. In 2008, the taxpayer, a nonresident alien individual, sold her interest in a US partnership, recognizing ordinary income resulting from the inventory gain, and treated the income as foreign-source income not subject to US tax. The Commissioner disagreed, instead treating the inventory gain as US-source income subject to tax in the US. When a partner sells an interest in a partnership, IRC Section 741 generally treats any gain or loss realized on the sale as gain or loss on the sale or exchange of a capital asset (i.e., capital gain or loss), "except as otherwise provided in [IRC S]ection 751 (relating to unrealized receivables and inventory items)." When the sale or exchange of a partnership interest is attributable to either unrealized receivables or inventory items of the partnership, IRC Section 751(a) treats the amount attributable to those assets as an amount realized from the sale or exchange of property "other than a capital asset" (i.e., as ordinary income). Under the IRC Section 751(a) regulations, the selling partner's ordinary income is the gain or loss that the partnership would allocate to the selling partner if the partnership sold its unrealized receivables and inventory items for fair market value immediately before the partnership interest sale. Nonresidents are generally subject to tax on US-source fixed or determinable annual or periodic income, or on effectively connected income. IRC Section 864(c)(8) treats gain or loss from a nonresident alien individual's or foreign corporation's sale or exchange of an interest in a partnership that is engaged in a US trade or business as effectively connected with that US trade or business. IRC Section 864(c)(8) is effective for sales, exchanges or other dispositions that occur on or after November 27, 2017. The events at issue in this case occurred in 2008, predating the enactment of IRC Section 864(c)(8). Without a specific sourcing provision governing income from the disposition of a partnership interest, the Court of Appeals noted that the provisions governing the sale of personal property apply. Under the general rule in IRC Section 865(a), income realized from the sale of personal property is sourced based on the residence of the seller; accordingly, income realized from the sale of personal property by a nonresident is generally foreign-source income. The general sourcing rule is subject to several statutory exceptions, including for inventory. In particular, IRC Section 865(b) provides that income derived from the sale of inventory (or a portion thereof) may be foreign-source or US-source depending on various context-specific considerations related to the sale (see, e.g., IRC Sections 861(a)(6), 862(a)(6), and 863). In her motion for summary judgment, the taxpayer contended thata nonresident's sale of a US partnership interest is not subject to US federal income tax because the gain would be sourced outside of the US under the general sourcing rule for the sale of personal property under IRC Section 865(a) (unless the gain is effectively connected with a US trade or business, which the taxpayer maintained was not the case). The taxpayer relied on Grecian Magnesite Mining, Industrial & Shipping Co. v. Commissioner, 149 T.C. No. 3 (July 13, 2017) (Grecian Magnesite), where the Tax Court concluded that a partnership interest is a single, indivisible capital asset, adopting an "entity" rather than an "aggregate" approach. While the taxpayer and the Tax Court agreed that IRC Section 751(a) requires gain from the sale of a partnership interest attributable to inventory to be taxed as ordinary income, the taxpayer maintained that IRC Section 751 "is not a sourcing rule," and does not go farther than to characterize the proceeds of a sale as ordinary income where applicable. In contrast, the Commissioner took the position that IRC Section 751(a) not only characterizes the portion of the gain attributable to inventory as ordinary income but also deems the income as "derived from the sale of inventory property" for sourcing purposes. Thus, instead of the entire gain being treated as foreign-source income under IRC Section 865(a), the portion of the gain attributable to inventory is subject to the provisions of IRC Section 865(b) and thus potentially taxable as US-source income. The Tax Court agreed with the Commissioner's view. Disagreeing with the Tax Court, the Court of Appeals held in favor of the taxpayer. While IRC Section 751(a) characterizes inventory gain realized on the sale of a US partnership interest as ordinary income, the Court concluded, it does not also treat this income as derived from the sale of the underlying inventory for sourcing purposes. According to the Court of Appeals, the requirement under IRC Section 751 to treat inventory gain as ordinary income is an exception to the general rule of IRC Section 741 that gain from the sale or exchange of a partnership interest is treated as gain from the sale of a capital asset. That treatment, however, does not operate to recharacterize the asset being sold from a partnership interest to inventory itself. Moreover, the Court of Appeals found that a mandate to treat inventory gain as ordinary income differs from a mandate to treat the income as gain from the sale of inventory in other respects; if Congress had wanted to convey something more encompassing on this matter, the Court said, it presumably would have done so. The Commissioner relied in part on the legislative history to IRC Section 751 to support the argument that inventory gain should be treated separately from gain on the partnership interest under IRC Section 741. However, the Court of Appeals interpreted the legislative history as focused on preventing the sale of a partnership interest from converting ordinary income into capital gain but not on treating the selling partner as actually selling IRC Section 751 property for other purposes of the Code. Accordingly, the Court of Appeals held that IRC Section 751(a) does not render the taxpayer's inventory gain taxable as income from the sale of inventory because it does not change the fact that the taxpayer sold her US partnership interest and not the underlying inventory. As a result, the taxpayer realized foreign-source ordinary income, which was not subject to US tax. With the enactment of IRC Section 864(c)(8), the relevance of the Rawat decision for sourcing purposes may be limited to transactions that predate TCJA. In the partnership context, subchapter K generally applies both aggregate and entity principles to the US federal tax treatment of partnerships, and typically views the sale of a partnership interest under entity principles. The Rawat decision supports the notion that entity principles prevail in the context of a sale or exchange of a partnership interest, subject to an overriding provision enacted in the Code. For taxpayers that have taken a position based on the Tax Court's holding that gain or loss from a sale by a US person of a partnership interest in a foreign partnership with foreign activities is foreign-source income, such an approach is unlikely to prevail under the Court of Appeals' rationale. The Court of Appeals' decision in Rawat may be instructive in certain analogous situations. First, the case may shed light on the holding period that a former partner should take in stock it receives upon contributing a partnership interest to a corporation in an IRC Section 351 transfer. The IRS has taken the view, in Revenue Ruling 84-111, 1984-2 C.B. 88 (Situation 3), that a partner must take a new holding period in the stock received to the extent the stock is attributable to the partnership's underlying IRC Section 751 property. Requiring a bifurcated holding period under this approach has been the subject of debate given that the actual property exchanged by the former partners consisted of interests in a partnership (i.e., capital assets under IRC Section 1221(a)) rather than the partnership's underlying property. The Court of Appeals' holding in Rawat follows an entity approach to the sale or exchange of a partnership interest and supports treating a transferor partner's holding period in stock received in an IRC Section 351 transfer as tacked in its entirety. Similarly, the Court of Appeals' decision supports applying entity principles for installment sale reporting of sales of partnership interests. In Revenue Ruling 89-108, 1989-2 C.B. 100, the IRS ruled that a partner that sells its interest in a partnership is not eligible to use the installment sale method to the extent of a partnership's IRC Section 751 property. The ruling concludes that "because [IRC S]ection 751 effectively treats a partner as if the partner had sold an interest in the [IRC S]ection 751 property of the partnership," the portion of the gain attributable to that property (in the case of the ruling, inventory) is not reportable under the installment method. The Fifth Circuit Court of Appeals in Mingo vs. Comm'r., 773 F.3d 629 (5th Cir. 2014) arrived at a similar result, denying a selling partner's use of the installment method for a partnership's underlying unrealized receivables (without addressing entity principles in much detail). In respecting the asset being sold or exchanged as the partnership interest itself under an entity theory, the Court of Appeals' decision in Rawat supports generally permitting the use of the installment sale method in full upon the sale of a partnership interest, regardless of any underlying IRC Section 751 property. (Note, however, that the installment sale method still would not be available for IRC Section 751 amounts related to IRC Sections 1245 or 1250 recapture, as specifically provided in IRC Section 453(i).)
Document ID: 2024-1462 | ||||||