Revenue Ruling 91-32

Internal Revenue Service

1991-1 C.B. 107

 

 

 

26 CFR 1.864-4: U.S. source income effective­ly connected with U.S. business.

(Also Sections 701, 702, 704, 741, 865, 875.)

 

Partnership effectively connected income look-through. Gain or loss of a foreign partner from a disposition of an interest in a partnership that conducts a trade or business through a fixed place of business or has a permanent establishment in the U.S. is gain effectively connected with such trade or business (or loss allocable to such gain) or is gain attributable to a permanent establishment (or loss allocable to such gain).

 

Rev. Rul. 91-32

 

ISSUE

 

What are the United States tax con­sequences of the disposition of a for­eign partner's interest in a domestic or foreign partnership that conducts a trade or business through a fixed place of business or has a permanent estab­lishment in the United States?

 

FACTS

 

Situation 1

 

FP1, a nonresident alien individual, is a partner in partnership PS1. PS1, which is not a publicly traded part­nership within the meaning of section 7704 of the Internal Revenue Code, is engaged in a trade or business through a fixed place of business in the United States. PS1 owns appreci­ated real and personal property locat­ed in Country X. PS1 also owns appreciated personal property located in the United States that is used or held for use in PS1’s trade or busi­ness within the United States (collec­tively, the "ECI property"). PS1 does not trade in stocks, securities or commodities. None of the ECI prop­erty is a United States real property interest within the meaning of section 897 of the Code. FP1 disposes of his partnership interest in a transaction entered into after March 18, 1986.

 

Situation 2

 

The facts are the same as those in Situation 1 . In addition, FP1 has a distributive share of 25 percent of the income, gain, loss, deduction and credit of PS1. The assets of PS1 consist of the following:

 

 

FP1 did not contribute property to the partnership in anticipation of de­riving a United States tax benefit under these rules from a subsequent sale of his partnership interest. FP1’s adjusted basis in his partnership interest is $375,000. FP1 sells its partner­ship interest for $475,000.

 

Situation 3

 

FP2, an alien individual resident in Country Y, is a partner in partnership PS2. The United States and Country Y are parties to a treaty whose provi­sions are identical to those of the Draft United States Model Income Tax Treaty (June 16, 1981) (the Trea­ty). PS2, which is not a publicly traded partnership within the meaning of section 7704 of the Code, has a permanent establishment in the Unit­ed States within the meaning of the Treaty. The assets of PS2 consist of immovable and movable property lo­cated in Country Y, and movable property located in the United States that are assets of the permanent es­tablishment. FP2 disposes of his part­nership interest in a transaction en­tered into after March 18, 1986.

 

LAW AND ANALYSIS

 

Situation 1

 

Section 701 of the Code provides that a partnership is not subject to income tax, but instead its partners are liable for the tax in their separate or individual capacities. Each partner must take into account separately the partner's distributive share of the items of income, gain, loss, deduction or credit of the partnership, as de­scribed in section 702 and the regula­tions thereunder. A partner's distribu­tive share of such items is determined pursuant to section 704 and the regu­lations thereunder.

 

The determination of the source and character of a foreign partner's income from the disposition of a partnership interest depends upon the application of sections 864, 865, 875 and 741 of the Code.

 

Pursuant to section 875(1) of the Code, a nonresident alien individual or foreign corporation that is a part­ner in a partnership engaged in a trade or business in the United States is itself considered to be so engaged. Because PS1 is engaged in a trade or business in the United States, FP1       is also so engaged since he is a partner in PS1.

 

For foreign persons other than a controlled foreign corporation within the meaning of section 957(a) of the Code, section 865 applies to transac­tions entered into after March 18, 1986. Pub. L. No. 99-514, section 1211(c)(2), 100 Stat. 2085, 2536. Sec­tion 865(e)(2) provides, inter alia, that income from the sale of personal property by a nonresident will be sourced in the United States if the nonresident has a fixed place of busi­ness in the United States and if the income is attributable to such fixed place of business. A foreign partner of a partnership that is engaged in a trade or business through a fixed place of business in the United States itself has a fixed place of business in the United States, since the foreign partner is considered to be engaged in such trade or business pursuant to section 875(1). Income from the dis­position of a partnership interest by the foreign partner will be attribut­able to the foreign partner's fixed place of business in the United States. See section 865(e)(3); cf . Unger v. Commissioner, T. C. Memo. 1990-15, 58 TCM 1157, 1159. Ac­cordingly, to the extent provided be­low, income from FP1’s disposition of his partnership interest will be sourced in the United States.

 

Section 864(c)(2) of the Code pro­vides that certain gain or loss from sources within the United States from the sale or exchange of a capital asset is gain that is effectively connected with the conduct of a United States tirade or business ("ECI gain"), or is loss that is allocable to ECI gain ("ECI loss"). Factors considered in determining whether the gain or loss is ECI gain or ECI loss within the meaning of section 864(c)(2) include whether the gain or loss is derived from an asset that is used or held for use in the conduct of a trade or business in the United States, or whether the activities of that trade or business were a material factor in the realization of the gain or loss. The rules of section 1.864-4(c)(2) of the regulations apply to determine wheth­er an asset is used or held for use in the conduct of a trade or business within the United States, while the rules of section 1.864-4(c)(3) apply to determine the character of gain or loss realized directly from the active conduct of the trade or business.

 

Since a foreign partner's gain or loss from the disposition of its inter­est in a partnership is not gain or loss realized directly from the active con­duct of a trade or business within the United States, the character of the foreign partner's gain or loss must be determined pursuant to the rules of section 1.864-4(c)(2) of the regula­tions. By virtue of its interest in the partnership, the foreign partner is considered to be engaged in a trade or business through the partnership's fixed place of business in the United States. Moreover, the value of the trade or business activity of the part­nership affects the value of the for­eign partner's interest in the partner­ship. Consequently, an interest in a partnership that is engaged in a trade or business through a fixed place of business in the United States is an ECI asset of a foreign partner. See section 1.864-4(c)(2) of the regula­tions.

 

A partnership, however, may also own property that, if disposed of by the partnership, would produce for­eign source income that generally would not be subject to United States tax. Amounts received by a foreign partner from a disposition of its part­nership interest may thus be attribut­able to unrealized gain or loss of the partnership representing the foreign partner's potential distributive share of foreign source items that, if real­ized by the partnership, generally would not be gain or loss to the foreign partner described in section 864(c).

 

Subchapter K of the Code is a blend of aggregate and entity treat­ment for partners and partnerships. Compare section 751 of the Code with section 741. For purposes of applying provisions of the Code not included in subchapter K, a partner­ship may be treated as an aggregate of its partners or as an entity distinct from its partners, depending on the purpose and scope of such provisions. Rev. Rul. 89-85, 1989-2 C.B. 218, 219; see Casel v. Commissioner, 79 T.C. 424 (1982). The treatment of amounts received by a foreign partner from a disposition of a partnership interest must therefore be considered in connection with the general pur­pose and scope of section 864(c) and section 865(e). Pursuant to section 865(e)(3) the principles of section 864(c)(5) are applied to determine whether gain or loss from a sale is attributable to an office or fixed place of business for purposes of section 865(e)(1) and (2), so the same analysis applies to both sections 864(c) and 865(e).

 

Characterizing the entire amount of gain or loss from a foreign partner's disposition of a partnership interest as United States source ECI gain or ECI loss would effectively subject to the tax jurisdiction of the United States items that may not be described in section 864(c) of the Code, a result which Congress did not in­tend. See S. Rep. No. 1707, 89th Cong., 2d Sess. 17 (1966). Further­more, treating the gain or loss real­ized by a foreign partner from the disposition of an interest in a partner­ship that is engaged in a United States trade or business entirely as United States source ECI gain or ECI loss may be conceptually inconsistent with other sections of the Code. For example, section 897(g) of the Code, which governs the treatment of a foreign partner's disposition of an interest in a partnership that has a United States real property interest, generally treats as ECI gain or ECI loss the amount that is attributable to a United States real property interest of the partnership. This provision evidences the view of Congress that a foreign partner's gain or loss from the disposition of an interest in a partnership that is engaged in a trade or business through a fixed place of business in the United States need not always be treated as ECI gain or ECI loss from United States sources in its entirety.

 

Accordingly, in applying sections 864(c) and 865(e) of the Code, it is appropriate to treat a foreign part­ner's disposition of its interest in a partnership that is engaged in a trade or business through a fixed place of business in the United States as a disposition of an aggregate interest in the partnership's underlying property for purposes of determining the source and ECI character of the gain or loss realized by the foreign part­ner. The determination of the source and the ECI character of gain or loss of a foreign partner from the disposi­tion of a partnership interest will therefore be determined in the man­ner described below.

 

A foreign partner's gain or loss from the disposition of an interest in a partnership that is engaged in a trade or business through a fixed place of business in the United States will be ECI (United States source) gain or loss to the extent such gain or loss is attributable to ECI (United States source) property of the partnership. The gain or loss attributable to the ECI property of the partner­ship is an amount that bears the same ratio to gain or loss realized by the foreign partner from the disposition of its partnership interest as the for­eign partner's distributive share of partnership net ECI gain or loss would have borne to the foreign part­ner's distributive share of partnership net gain or loss if the partnership had itself disposed of all of its assets at fair market value at the time the foreign partner disposes of its part­nership interest. In computing the foreign partner's distributive share of net gain or loss of the partnership, net ECI gain or loss and net non-ECI gain or loss are computed separately. Thus, net non-ECI loss will not offset ECI gain, and net ECI loss will not offset net non-ECI gain.

 

Further, if a foreign partner realiz­es a loss on the disposition of its partnership interest, and if its distrib­utive share of ECI gain or loss from the deemed disposition of ECI assets by the partnership would be a net ECI gain, then none of the loss realized by the foreign partner on the disposition of the partnership interest shall be ECI loss. If a foreign partner realizes a gain on the disposition of its partnership interest, and if its distributive share of ECI gain or loss from the deemed disposition of ECI assets by the partnership would be a net ECI loss, then none of the gain realized by the foreign partner on the disposition of the partnership interest shall be ECI gain.

 

In applying these rules, a foreign partner's gain on the disposition of an interest in a partnership that is engaged in a U.S. trade or business will be presumed to be U.S. source ECI gain in its entirety, and a foreign partner's loss on such a disposition will be presumed to be foreign source non-ECI loss in its entirety, unless the partner is able to produce upon re­quest information showing the dis­tributive share of net ECI and net non-ECI gain or loss that such part­ner would have been allocated if the partnership sold all of its assets. This presumption is a specific application of the general principle that the bur­den of proof is on the taxpayer.

 

Note that if a foreign partner con­tributes property to the partnership in anticipation of a subsequent sale of its partnership interest to derive a United States tax benefit under the approach taken under this ruling, the contribution may be disregarded un­der general tax principles in determining the tax consequences of the subse­quent sale.

 

For purposes of these rules, the ECI (United States source) property of a partnership does not include United States real property interests held by the partnership. The rules of section 897(g), rather than the rules described in this ruling, govern the treatment of amounts received from the disposition of an interest in a partnership that are attributable to a United States real property interest of the partnership, and are applied be­fore the rules described in this ruling are applied.

 

Situation 2

 

The character of the $100,000 gain realized by FP1 is determined under section 741 and section 751 of the Code, and is capital gain in this case. FP1’s gain from the disposition of his partnership interest that is attribut­able to the ECI property of PS1 is an amount that bears the same ratio to the gain realized by FP1 from the disposition of his partnership interest as FP1’s distributive share of partner­ship net ECI gain would have borne to his distributive share of partner­ship net gain if the partnership had disposed of all of its assets at fair market value on the date FP1 dispos­es of his partnership interest.

 

Upon a disposition of its ECI asset, the partnership would realize United States source ECI gain of $300,000 (fair market value of PS1's ECI prop­erty of $500,000 less basis of $200,000), of which 25 percent, or $75,000, would represent FP1's dis­tributive share. Upon a disposition of all of its non-ECI assets, the partner­ship would realize a net gain of $100,000 (fair market value of ma­chinery and real property outside the United States of $1,100,000 less basis of $1,000,000), of which FP1’s 25 percent distributive share is $25,000.

 

FP1’s gain from the disposition of his partnership interest that is attrib­utable to ECI (United States source) property of the partnership is an amount that bears the same ratio to $100,000 (FP1's gain from the dispo­sition of its partnership interest) as $75,000 (FP1’s distributive share of the partnership's ECI (United States source) gain) bears to $100,000 (the sum of FP1’s distributive share of the partnership's net ECI gain and net non-ECI gain). Accordingly, the portion of FP1's gain from the disposi­tion of his partnership interest that is attributable to the ECI property of PS1 equals $75,000. Note that if the partnership's assets included United States real property interests, FP1 also would be subject to tax pursuant to section 897(g) on the amount attributable to the United States real property interests of the partnership. In this case, because the appreciated assets other than those used by PS1 in its United States trade or business are located outside the United States, the remaining $25,000 gain realized by FP1 will be foreign source capital gain that is not effectively connected with the conduct of a trade or busi­ness in the United States.

 

Situation 3

 

The Treaty generally exempts from United States tax gain from the dis­position of movable property by a resident of the United States treaty partner. See Article 13(3) (Gains) of the Treaty. However, this rule does not apply if such gain is from the alienation of movable property that are assets of a permanent establish­ment in the United States.

 

A foreign partner of a partnership that has a permanent establishment in the United States is treated as itself having a permanent establish­ment. Donroy, Ltd. v. United States, 301 F.2d 200 (9th Cir. 1962); see Rev. Rul. 85-60, 1985-1 C.B. 187. More particularly, "the office or permanent establishment of a partner­ship is the office of each of its partners, whether general or limit­ed." Unger v. Commissioner, T. C. Memo. 1990-15, 58 TCM 1157, 1159, citing Donroy, Ltd. v. United States, supra. Accordingly, FP2 is consid­ered to have a permanent establish­ment in the United States because he is a partner in PS2.

 

The determination whether gain from the alienation of movable prop­erty is attributable to a permanent establishment in the United States is generally made by applying principles analogous to those governing whether an item is effectively connected with the conduct of a trade or business in the United States, though the "attrib­utable to" concept of the Treaty is more limited in its scope than the "effectively connected" concept of the Code. See Rev. Rul. 81-78, 1981-1 C.B. 604. The principles applied are substantially similar, howev­er, when the amounts at issue are those that would be described in sec­tion 864(c)(2) of the Code if the Treaty were not applied. Accordingly, for the reasons discussed in Situation 1, a disposition of an interest in a partnership that has a permanent es­tablishment in the United States will be treated as resulting in gain that is attributable to the permanent estab­lishment to the extent provided be­low.

 

It is appropriate under the Treaty to look to a foreign partner's interest in the assets of the partnership to determine the amount of the foreign partner's gain from the disposition of its partnership interest that is attribut­able to a United States permanent establishment. Cf . Commentary on Article 1 of the OECD Model Double Taxation Convention on Income and Capital, paragraphs 2-5 (1977). Gain of FP2 from the disposition of its interest in PS2 will thus be subject to United States tax only to the extent such gain is attributable to the unreal­ized gain of the partnership's assets attributable to the partnership's per­manent establishment, and loss will be allocable to FP2’s gain from sources within the United States that is attributable to a permanent estab­lishment of FP2. Such gain or loss is to be determined in the manner de­scribed in Situation 1.

 

HOLDINGS

 

Situation 1

 

Gain or loss of a foreign partner that disposes of its interest in a part­nership that is engaged in a trade or business through a fixed place of business in the United States will be United States source ECI gain or will be ECI loss that is allocable to United States source ECI gain, to the extent that the partner's distributive share of unrealized gain or loss of the partner­ship would be attributable to ECI (United States source) property of the partnership.

 

Situation 2

 

FP1’s gain from the disposition of his partnership interest that is attrib­utable to ECI (United States source) property of the partnership is an amount that bears the same ratio to $100,000 (FP1’s gain from the dispo­sition of its partnership interest) as $75,000 (FP1’s distributive share of the partnership's ECI (United States source) gain) bears to $100,000 (the sum of FP1’s distributive share of the partnership's net ECI gain and net non-ECI gain). Accordingly, the portion of FP1’s gain from the disposi­tion of his partnership interest that is attributable to the ECI property of PS1 equals $75,000.

 

Situation 3

 

Under the Treaty, gain of a foreign partner that disposes of its interest in a partnership that has a United States permanent establishment is gain that is attributable to a permanent establish­ment and is subject to United States tax under the Treaty, to the extent that the partner's potential distributive share of unrealized gain of the part­nership is attributable to the partner­ship's permanent establishment.