New U.S. Tax Challenges for Cross-border Real Estate Investments

Date: November 2018

 

Recent changes in the tax laws governing investments in part-nerships will impact past, present and future transactions by Canadian investors in partnerships with U.S. assets.

The partnership tax rules in the Internal Revenue Code are without a doubt the most difficult to understand and often are an area where frequent compliance errors can be found on both sides of the border — Canadian reporting of these investments, and U.S. reporting. As well, these same rules often apply to LLC’s with more than one member.

 

This article is adapted from a more comprehensive update and study of the subject to be found in my 2,500 page treatise The Tax Advisor’s Guide to the Canada U.S. Tax Treaty of which I am the Principal-Author, and Editor in Chief (Thomson-Reuters, looseleaf and available on TaxNetPro) (see Chapter 6 — Real Property, and Chapter 13 — Capital Gains). This work retails for $1,000.00 and is published by the largest legal publisher in the world. The contents of this article are purely for illustrative purpose, are not meant to be current or intended to be used as a substitute for timely and proper multi-jurisdictional and multi-disciplinary legal counsel.

 

The shifting of the proverbial tectonic plates in U.S. tax reform mandate that any practitioner or investor considering the treaty understand the impact of the corporate and international rules. For new investors, coupling a legal strategy with a financial model and compliance checklist is the safest way to understand the monetary impact of an entity choice.

 

A partnership generally is not treated as a taxable entity, but rather, income of the partnership is taken into account on the tax returns of the partners and they are issued K-1s by the general partner. The character (as capital or ordinary) of partnership items passes through to the partners as if the items were realized directly by the partners.

 

A partner holding a partnership interest includes in income its distributive share (whether or not actually distributed) of partner-ship items of income and gain, including capital gain eligible for the lower tax rates, and deducts its distributive share of partnership items of deduction and loss. A partner’s basis in the partnership interest is increased by any amount of gain and decreased by any amount of losses thus included. These basis adjustments prevent double taxation of partnership income to the partner. Money distributed to the partner by the partnership is taxed to the extent the amount exceeds the partner’s basis in the partnership interest.

 

Gain or loss from the sale or exchange of a partnership interest generally is treated as gain or loss from the sale or exchange of a capital asset. However, the amount of money and the fair market value of property received in the exchange that represent the partner’s share of certain ordinary income-producing assets of the partnership give rise to ordinary income rather than capital gain. In general, a partnership does not adjust the basis of partnership property following the transfer of a partnership interest unless either the partnership has made a one-time election to do so or the partnership has a substantial built-in loss immediately after the transfer. If an election is in effect or the partnership has a substantial built-in loss immediately after the transfer, adjustments are made with respect to the transferee partner. These adjustments are to account for the difference between the transferee partner’s proportionate share of the adjusted basis of the partnership property and the transferee partner’s basis in its partnership interest. The effect of the adjustments on the basis of partnership property is to approximate the result of a direct purchase of the property by the transferee partner. These ordinary income producing assets are unrealized receivables of the partnership or inventory items of the partnership (“751 assets”).

 

A foreign person that is engaged in a trade or business in the United States is taxed on income that is “effectively connected” with the conduct of that trade or business (“effectively connected gain or loss”). Partners in a partnership are treated as engaged in the conduct of a trade or business within the United States if the partnership is so engaged. Any gross income derived by the foreign person that is not effectively connected with the person’s U.S. business is not taken into account in determining the rates of U.S. tax applicable to the person’s income from the business.

 

Non-business income received by foreign persons from U.S. sour-ces is generally subject to tax on a gross basis at a rate of 30 percent, and is collected by withholding at the source of the payment. The income of non-resident aliens or foreign corporations that is subject to tax at a rate of 30 percent is fixed, determinable, annual or periodical income that is not effectively connected with the conduct of a U.S. trade or business. Among the factors taken into account in determining whether income gain or loss is effectively connected gain or loss are the extent to which the income gain or loss is derived from assets used in or held for use in the conduct of the U.S. trade or business, and whether the activities of the trade or business were a material factor in the realization of the income gain or loss (the “asset use” and “business activities” tests). In determining whether the asset use or business activities tests are met, due regard is given to whether such assets or such income gain or loss were accounted for through such trade or business. Thus, notwithstanding the general rule that source of gain or loss from the sale or exchange of personal property is generally determined by the residence of the seller, a foreign partner may have effectively connected income by reason of the asset use or business activities of the partnership in which he is an investor.

 

Special rules apply to treat gain or loss from disposition of U.S. real property interests as effectively connected with the conduct of a U.S. trade or business. To the extent that consideration received by the nonresident alien or foreign corporation for all or part of its interest in a partnership is attributable to a U.S. real property interest, that consideration is considered to be received from the sale or exchange in the United States of such property. In certain circumstances, gain attributable to sales of U.S. real property interests may be subject to withholding tax of ten percent of the amount realized on the transfer.

 

Under a 1991 revenue ruling, in determining the source of gain or loss from the sale or exchange of an interest in a foreign partner-ship, the IRS applied the asset-use test and business activities test at the partnership level to determine the extent to which income derived from the sale or exchange is effectively connected with that U.S. business (the so called ‘entity approach’). Under the ruling, if there is unrealized gain or loss in partnership assets that would be treated as effectively connected with the conduct of a U.S. trade or business if those assets were sold by the partnership, some or all of the foreign person’s gain or loss from the sale or exchange of a partnership interest may be treated as effectively connected with the conduct of a U.S. trade or business.

 

However, a 2017 Tax Court case rejects the logic of the ruling and instead holds that, generally, gain or loss on sale or exchange by a foreign person of an interest in a partnership that is engaged in a U.S. trade or business is foreign-source.

 

 

The Court in a 2017 decision rejects the IRS ruling Rev. Rul. 91-32, and instead holds that, generally, gain or loss on the sale or ex-change by a foreign person of an interest in a partnership that is engaged in a U.S. trade or business is foreign-source.

 

The IRS determined deficiencies in income tax for GMM of $322,056 for 2008 and $1,780,563 for 2009. The statutory notice of deficiency issued to GMM resulted from the IRS determination that GMM must recognize as income within the U.S. the gain it realized on the redemption of its interest in Premier Chemicals, LLC (“Premier”). A portion of the gain that GMM realized from the redemption of its partnership interest in Premier pertained to Premier’s U.S. real property interests (see our discussion of FIRPTA in this Chapter) and GMM later conceded this point. However, in dispute was the remainder of the gain not attributable to real property. GMM’s principal place of business was Athens, Greece. Its business was extracting, producing and commercializing magnesia and magnesite for global sale. GMM had no office or employees in the U.S.; however, under the Code, the business operations of Premier of extracting, producing, and distributing magnesite extracted or mined in the U.S. are attributable to its foreign partners. Premier is a Delaware LLC though treated as a partnership for U.S federal income tax purposes. Under various agreements, Premier was to redeem GMM’s membership interest in Premier.

 

The IRS after audit determined that GMM should have recognized U.S. source capital gain net income of $1 million for 2008 and $5.2 million for 2009 from the redemption of its interest in Premier. The IRS position arose from its conclusions that as a result of GMM’s membership interest in Premier, GMM’s capital gain was effectively connected with a trade or business engaged in or within the U.S. The parties agreed that part of the gains for 2008 and for 2009 are attributable to the sale of U.S. real property pursuant to section 897(g) and are thus considered U.S. source income effectively with GMM’s U.S. trade or business. The Court found that the redemption gain arose from sale or exchange of the partnership interest and not from the sale or exchange of the partner’s portion of individual items of partnership property. The Court also noted that the gain should generally be considered a gain from the sale or exchange of a capital asset (except for assets in 751). The Court regarded GMM’s disputed gain as having arose from personal property in the form of an indivisible capital asset. Although the gain from the sale or exchange of a capital asset may be effectively connected with the conduct of a trade or business in the U.S., the test for ‘ECI’ only applies to gains from sources within the U.S. The Court ultimately held that the disputed gain was a capital gain that was not U.S. source income and that was not effectively connected with a U.S. trade or business and declined to follow Rev. Rul. 91-32.

 

 

Generally, under the provision, gain or loss from the sale or ex-change of a partnership interest is effectively connected with a U.S. trade or business to the extent that the transferor would have had effectively connected gain or loss had the partnership sold all of its assets at fair market value as of the date of the sale or exchange. The provision requires that any gain or loss from the hypothetical asset sale by the partnership be allocated to interests in the partnership in the same manner as non-separately-stated income and loss.

 

The provision also generally requires the transferee of a partnership interest to withhold 10 percent of the amount realized on the sale or exchange of a partnership interest unless the transferor certifies that the transferor is not a nonresident alien individual or foreign corporation. If the transferee fails to withhold the correct amount, the partnership is required to deduct and withhold from distributions to the transferee partner an amount equal to the amount the transferee failed to withhold. These rules dealt with in IRC Section 864(c)(8) and IRS Section 1446(f) as amended by TCJA are effective for sales and exchanges after November 26, 2017 and withholding after December 31, 2017. The new rules are highly complex and the foregoing is intended to bring the tax advisor into awareness of the new changes.

 

Critically, [emphasis added] the application of the new law changes must be considered in context of the intentions regarding TCJA with respect to treaties and IRS guidance reinforced by TCJA history on the taxation of gains where foreign investors have permanent establishments. Other new laws to be considered but not dealt with in this article include the deduction for qualified business income.