Private equity funds have long had to deal with non-US (and to a lesser extent, tax-exempt) investors’ concerns about the adverse tax consequences of investing in operating US LLCs or other pass-through entities (Operating Partnerships). On July 13, 2017, the US Tax Court ruled that a foreign corporation did not have to pay US federal income tax on certain gain realized on the redemption of its interest in an Operating Partnership.1 The ruling rejected the IRS’s long-standing position that a non-US partner’s gain on the sale of an interest in an Operating Partnership is income effectively connected with a US trade or business (ECI) and subject to US federal income tax.
The implications of the Tax Court’s decision are far-reaching for private equity funds and non-US investors. While it may be too early for private equity funds to change the blocker structures offered to non-US investors when investing in Operating Partnerships, non-US blockers may be a good solution for an Operating Partnership with the right tax profile. In addition, private equity fund sponsors may see certain non-US investors that are not averse to filing US tax returns decline blocker structures offered by the fund and, instead, invest unblocked into Operating Partnerships. Private equity funds with Cayman feeders and non-US investors that have reported ECI from the sale of their interests in Operating Partnerships should consider filing tax refund claims with the IRS for all open tax years.
Tax Court Ruling
Grecian Magnesite Mining, Industrial & Shipping Co., S.A. (GMM), a foreign corporation, owned an interest in a partnership engaged in the business of extracting, producing and distributing magnesite in the United States. In 2008, the partnership redeemed GMM’s interest, resulting in $6 million of gain, which GMM did not report as ECI. The IRS claimed that the gain was ECI and therefore taxable. In response, GMM filed a petition with the Tax Court.
The IRS’s controversial position regarding the sale or redemption of an interest in an Operating Partnership is articulated in a 1991 Revenue Ruling (Rev. Rul. 91-32). Rev. Rul. 91-32 holds that a non-US partner’s gain on the disposition of an interest in an Operating Partnership is ECI and subject to US tax to the extent attributable to property of the Operating Partnership that is used or held for use in its US trade or business. The IRS arrived at this result by stating that the US office of an Operating Partnership is treated as a US office of its partners and that gain realized by a non-US partner from the sale of an interest in such Operating Partnership is attributable to that US office.
Commentators have criticized Rev. Rul. 91-32 since its publication, questioning in particular whether the ruling is supported by law or simply reflects IRS policy. Notwithstanding this criticism, the IRS has consistently applied its position, which remained essentially unchallenged during the 25 years since Rev. Rul. 91-32’s publication. The Obama administration also indicated support for the ruling’s position by proposing to codify its holding.
All of this changed with the GMM case. The Tax Court did not follow Rev. Rul. 91-32, finding that GMM’s gain on the redemption of its partnership interest was better characterized as gain from the sale of an “indivisible capital asset,” rather than from the partnership’s underlying assets. The Tax Court noted that the look-through approach advanced by Rev. Rul. 91-32 was not supported by the Internal Revenue Code (Code) or regulations. It further found that GMM’s gain was not attributable to the partnership’s office and therefore improperly treated as ECI. In support of its ruling, the Tax Court pointed to the FIRPTA rules (US real property tax rules), which have a specific look-through to treat as ECI any gain attributable to a partnership’s US real property interests; under the IRS’s position, such rule would be unnecessary.
What Does This Mean for You?
By rejecting the controversial analysis in Rev. Rul. 91-32, the Tax Court’s decision, if sustained on appeal or acquiesced to by the IRS, may significantly change how private equity funds structure investments in Operating Partnerships for non-US investors. Of course, most non-US investors will continue to want blocker structures to avoid any direct US tax or tax return obligations. Historically, private equity funds have used US blocker corporations for non-US (as well as tax-exempt) investors when making investments in Operating Partnerships. This preference was due in part to the IRS’s position in Rev. Rul. 91-32. In addition, using a US blocker can make it possible to sell the blocker tax-free, albeit at a discounted price.
With the Tax Court’s ruling, however, structuring investments in Operating Partnerships through non-US blockers may become more appealing, especially in cases where an Operating Partnership does not have significant FIRPTA assets or has significant non-US assets. Indeed, there may be little down-side risk in using non-US blockers. Both US and non-US blockers are essentially taxed the same way on current income (both are taxed at the same rates and can be capitalized using blocker leverage to minimize the impact of current taxation). Moreover, while only non-US blockers are subject to the branch profits tax, the branch profits tax generally would not apply to a non-US blocker on the sale of an Operating Partnership. It may also be possible to manage the branch profits tax leakage on current income similarly to the way in which dividend withholding tax leakage is managed today in the case of a US blocker.
So Why Are We Suggesting Caution?
At this time, the issue remains unsettled. The IRS has not yet indicated whether it will acquiesce to or appeal the Tax Court’s decision. If the IRS appeals, it may win. Perhaps more importantly, the IRS may seek to overturn the Tax Court’s decision by issuing new regulations consistent with its position in Rev. Rul. 91-32, such as clarifying what it means to be “attributable” to a US office. Another possibility is that Congress will adopt changes to the Code to codify the holding in Rev. Rul. 91-32. One thing that does seem certain is that we have not heard the last of this issue.
During this time of uncertainty, before deciding on using a non-US blocker, fund sponsors should think carefully about the impact a reversal of the Tax Court’s decision will have on unwinding a non-US blocker structure. In general, selling a non-US blocker is likely to be materially more difficult than selling a US blocker. US strategic investors in particular may be adverse to buying a non-US blocker because of integration issues. Of course, if the IRS ultimately loses the issue or acquiesces, selling non-US blockers would be unnecessary because gain from the sale of an Operating Partnership would generally not be ECI. If the IRS ultimately wins or changes the rules of the game, however, selling US blockers will be back on the table. Fund sponsors using non-US blockers may at that point be able to convert them into US blockers, but some tax leakage is likely and delay in selling the US blockers may be necessary. Unfortunately, there will not be any way to unwind any sales of Operating Partnerships by non-US blockers made in the interim.
Takeaways for Fund Sponsors
The Tax Court case is a game changer. Fund sponsors should keep in mind, however, that this is just the start of the game and that the IRS has many cards it can play in response. Fund sponsors thinking about how best to serve their non-US investors should pay careful attention to the IRS’s next move. Fund sponsors should also discuss the pros and cons of using US versus non-US blockers with their tax advisors. Managing the branch profits tax and having the ability to unwind a non-US blocker structure in the event of a reversal will be key elements to any blocker structure analysis.
1 Grecian Magnesite Mining, Industrial & Shipping Co., S.A. v. Commissioner, 149 T.C. No. 3 (July 13, 2017), available at https://www.ustaxcourt.gov/UstcInOp/OpinionViewer.aspx?ID=11322.