After internally debating the case for three years, the US Tax Court recently issued a significant judgment that affects many non-US Persons who reside outside the US, but who have investments or business there.
By way of background, the US Tax Court is the main federal court where federal tax disputes between the taxpayer and federal government are heard and decided upon. Usually, judgments are published a few months after the trial, or up to nine months after if the case raises matters of national tax policy. In the case of Grecian vs. IRS, it took the court a few years to publish its opinion.
The facts of the case are simple. A Greek company – Grecian Magnesite Mining – acquired 12.6% in a US LLC headquartered and operating mines in the US. The Greek company itself had no direct connection with the US – no offices, no workers, no business.
At a certain stage, the Greek company sold its share in the LLC for a gain. The question before the court was whether this capital gain was subject to US tax. More specifically, was the sale of a partnership interest (the LLC was treated as a partnership) by a non-US Person subject to US capital gains tax? The consequences of the ruling would be significant – 42% corporate and state tax vs 0% tax.
At the heart of the dispute were two approaches to how a partnership is treated. According to one approach, favored by the Greek company, the “separate entity theory,” partnerships should be treated as a separate legal entity for tax purposes – separate from the partnership assets themselves. The result is that the transfer of a partner’s share in a partnership is considered the sale of an asset (the partnership interest), just like the sale of a share in an American corporation. As a rule, the US does not tax capital gains on gains from the sale of US securities.
The second approach, the “aggregate theory,” which the IRS supported, each partner holds a part of each partnership asset, and when a partner sells his share in the partnership, it is treated as if he sold his proportional share of the partnership assets. And in this case, any gain is subject to US capital gains tax.
In a densely written 55-page judgment, the court rejected the IRS position. The judge ruled that with regard to the sale of partnership interests, the separate entity theory should be used. In other words, when the partner sells his share, he sells an indivisible asset – not his share of the partnership’s assets. And accordingly, the sale of the partnership interest is not subject to US capital gains tax.
The court did not stop here. To overcome the first setback, the IRS put forward an alternative theory to support taxation of the gain: the gain was “effectively connected to a US trade or business.” The IRS had indeed been using this criteria for decades, although no court had ever ruled on the matter.
The court rejected the “US trade or business” test, handing the IRS a stinging defeat.
The court divided the analysis into two parts. First, the court stated that even if the partnership has American- based activity (such as a US office), there must be a substantial connection between the revenues and profits attributed to the foreign partner and the American presence.
The US presence must contribute meaningfully to the partner’s revenue and profits.
For example, if the partner is responsible for the activity in Israel, and not in the US, it may be that there is no substantive connection between the profits attributed to him and the American presence. However, what if the US presence does provide the Israeli partner with value with regard to Israel-based activity? Or if the Israeli partner does travel to the US for partnership business? Clearly, how such person conducts his/her affairs can have material impact on US tax liability of their salaries, bonuses, profits and promotions.
In the second part, the court ruled that there must be a significant connection between the nature of profit and the daily operational activity in the US. Here, the court ruled that while the operating profits arose in the US and were thus subject to federal income tax, not so with respect to capital gains. Here, the court ruled that the regular business of the partnership is not buying and selling partnership interests. The partnership ran a mining business.
And thus there is not sufficient connection between an increase in the value of the partnership interest and daily business activity.
It is important to note that the court carved out a big exception to the general ruling – US real estate. In the case of real estate, the court ruled that since the LLC did hold some US real estate, any gain attributable to the Greek company was subject to capital gains tax under FIRPTA.
Also, the court did not address the question of the US-Greece Tax Treaty. Instead it ruled that since there was no US tax liability, there is no need to address the treaty and any additional protections it may grant. In the case of Israelis, the same would apply with regard to the US-Israel Tax Treaty.
One last issue is that of Estate Tax. Many Israelis invest in US real estate, and these investments are often carried out through an LLC (often considered a partnership under US tax laws). If the investment is more than $60,000, then US estate tax law imposes a tax of 20-40% of the value of the US real estate at death.
How does this ruling impact estate tax? While the Grecian judgment does not address this matter, an argument can be made that the real estate investor’s share in the LLC is not considered a holding in real estate, but rather a holding of a partnership interest that may possibly not be subject to estate tax.
After the defeat, the IRS may appeal. An appeal would probably take a few more years, and until then the court’s ruling is law. Another possibility is that the US Treasury Department will issue regulations that override the court judgment. However, in view of the current situation of US President Donald Trump and Congress, it is not likely at all that this matter will be high up on the priority list.
So now is the time to plan accordingly.
The author is a US tax attorney residing in Israel. He is senior counsel at the Israeli law firm of Eitan, Mehulal & Sadot. He previously worked for the Estate & Gift Division of the IRS and the US Tax Court. This document does not constitute legal advice.