Tax Court finds that non-U.S. Partner is not taxable on gain from sale of interest in partnership operating a U.S. business
Author: Michael P. Flamenbaum and Hersh Verma
In a decision released on July, 13, 2017, the US Tax Court in Grecian Magnesite Mining, Industrial & Shipping Co., SA, v. Commissioner, 149 T.C. No. 3 (2017), held that a non-US partner’s gain from the redemption of an interest in a partnership that was engaged in a US trade or business was not subject to US federal income tax as effectively connected income except with respect to the portion of the gain attributable to the non-US partner’s share of the partnership’s US real property interests. In doing so, the Tax Court declined to follow IRS Revenue Ruling 91-32, 1991-1 C.B. 107, which held that a non-US partner’s gain on the sale of an interest in a partnership is ECI, and therefore is subject to US federal income tax, to the extent the gain is attributable to the partnership’s USTB.
In a decision released on July, 13, 2017, the US Tax Court in Grecian Magnesite Mining, Industrial & Shipping Co., SA, v. Commissioner, 149 T.C. No. 3 (2017) (Grecian), held that a non-US partner’s gain from the redemption of an interest in a partnership that was engaged in a US trade or business (USTB) was not subject to US federal income tax as effectively connected income (ECI), except with respect to the portion of the gain attributable to the non-US partner’s share of the partnership’s US real property interests. In doing so, the Tax Court declined to follow IRS Revenue Ruling 91-32, 1991-1 C.B. 107 (Rev. Rul. 91-32), which held that a non-US partner’s gain on the sale of an interest in a partnership is ECI, and therefore is subject to US federal income tax, to the extent the gain is attributable to the partnership’s USTB.
Rev. Rul. 91-32 relied on an “aggregate” theory of partnerships, treating a sale of a partnership interest in effect as a sale of an undivided interest in the partnership’s assets. This IRS position was controversial, but had not previously been challenged in court. The Tax Court in Grecian, in rejecting Rev. Rul. 91-32, held that absent an explicit exception, the “entity” theory of partnerships should apply, under which a partner is treated as owning an interest in an entity that is separate and distinct from an interest in the underlying assets. Because Congress explicitly carved out exceptions to the aggregate theory in narrow circumstances, such as Section 7511 (providing for ordinary income treatment on a sale of a partnership interest to the extent attributable to certain of the partnership’s ordinary income assets) and Section 897(g) (treating the disposition of an interest in a partnership as ECI to the extent gain is attributable to US real property interests), the court reasoned that “[t]he partnership provisions in subchapter K of the Code provide a general rule that the ‘entity theory’ applies to sales and liquidating distributions of partnership interests—i.e., that such sales are treated not as sales of underlying assets but as sales of the partnership interest.” Applying the entity theory approach, the court determined the capital gain from the redemption of Grecian’s partnership interest was not ECI and therefore not taxable for US federal income tax purposes.
It should be noted that the Obama Administration proposed codifying Rev. Rul. 91-32, and the US Treasury Department had announced its intent to issue regulations applying the principles of Rev. Rul. 91-32, although legislation was never adopted and regulations have not been promulgated.
Potential impact of Grecian
Non-US investors in partnerships conducting a USTB often participate through “blocker” structures, typically US corporations, to insulate them from ECI and the resulting direct US tax filing and payment obligations. US corporate blockers are subject to US taxation on their income from partnerships, as well as on any gain from a sale of the partnership interest. To avoid corporate level gain on the sale of a partnership interest, blockers often seek to sell the stock in the blocker, although such a sale does not allow the buyer a step-up in the basis of the partnership’s assets. It may be expected that the IRS will appeal Grecian and express its intent not to follow the decision. However, if the Grecian decision is upheld, non-US investors will likely re-examine the use of blockers, with the potential to increase the use of foreign blocker corporations that will not be subject to US taxation on the sale of partnership interests under Grecian.
Even prior to any IRS appeal, Grecian represents a significant shift that may enable non-US partners disposing of interests in partnerships engaged in a USTB to consider whether their gain is not subject to US federal income tax. Further, non-US persons that have treated a sale of a partnership interest as ECI based on Rev. Rul. 91-32 should consider whether to seek a refund for taxes paid for any open tax years.
SEC quarterly round-up
Author: Steven R. Howard
In his regular update Steven Howard discusses recent developments in the United States including the Second Circuit eliminating “meaningfully close personal relationship” element articulated in Newman for insider trading prosecutions.
SEC appoints new Investment Management Division Director and Co-Directors of the Enforcement Division
On August 31, 2017, the SEC announced that Dalia Blass has been named the new Director of the Investment Management Division. Ms. Blass joins the SEC staff from a private law firm and she returns to the SEC Staff after previously serving in the Division, most recently as the Assistant Chief Counsel.
On June 8, 2017, the SEC announced the appointments of Stephanie Avakian and Steven Peikin as the Co-Directors of the Enforcement Division. Ms. Avakian previously served as counsel to former SEC Commissioner Paul Carey, and Mr. Peikin previously served as Chief of the Securities and Commodities Fraud Task Force in the U.S. Attorney’s Office for the Southern District of New York.
SEC conducts electronic communications sweep
In July the SEC’s Office of Compliance Inspections and Examinations started a sweep examination of investment advisers and their use of electronic communications, including text messages, snapchat, tweets, Bloomberg messaging and other devices, as well as their policies and procedures to monitor, store and review such electronic communications.
SEC issues risk alert regarding cybersecurity examinations
On August 7, 2017, the SEC’s Office of Compliance Inspections and Examinations released a risk alert regarding its staff’s cybersecurity examinations of 75 registered broker-dealers, investment advisers and investment companies. The staff’s examinations focused on six areas: governance and risk assessment; access rights and controls; data loss prevention; vendor management; training; and, incident response.
The staff stated that, in general, cybersecurity practices have improved since the staff’s initial cybersecurity examinations in 2014, but identified weaknesses in policies and procedures, including policies that lack details and specific tailoring to advisers’ circumstances.
The staff identified the following examples of best practices.
- Maintaining a complete “inventory of data, information and vendors”;
- Providing “detailed cybersecurity-related instructions,” by including tracking requests for access and having policies and procedures specific to the modification of certain access rights;
- Maintaining “prescriptive schedules and processes for testing data integrity and vulnerabilities,” by testing a patch before deploying it firm-wide and analyzing the risks related to the patch;
- Requiring mandatory employee training at the time of hire and on a periodic basis thereafter; and
- Reviewing and approving cybersecurity policies and procedures by senior management.
SEC issues investor alert concerning ICOs
On August 28, 2017, the SEC’s Office of Investor Education and Advocacy released an Investor Alert, regarding potential scams involving companies engaged in initial coin offerings (ICOs). These frauds include “pump and dump” schemes involving publicly traded companies that claim to provide coin and token technologies. The SEC recently issued several trading suspensions on the common stock of First Bitcoin Capital Corp., CIAO Group, Strategic Global and Sunshine Capital because of claims these issuers made regarding investments in ICOs. The SEC cautioned investors to be wary of investing in any securities following a trading suspension.
Second Circuit Court delays Federal Court challenge to the constitutionality of the SEC’s administrative law judges
On June 1, 2017, a divided Second Circuit Court ruled that private equity manager, Lynn Tilton, cannot challenge the constitutionality of the SEC’s administrative law judges until the SEC has reached a verdict on its $200 million fraud case against her and her Patriarch Partners firm. The Second Circuit ruling concurs with rulings by the D.C. and Seventh Circuit Courts. In effect, the US Courts of Appeals agree that a plaintiff in an administrative law proceeding must make constitutionality claims first in the administrative proceeding which are subject to review by the administrative regulator, in the Tilton case, the SEC, after which an appeal to the federal Appellate Courts is permissible.
The constitutional issue in the Tilton case concerns the claim that the SEC’s administrative law judges are improperly installed by the personnel department of the SEC and not properly appointed by the U.S. President or the SEC Commissioners in accordance with the U.S. Constitution’s Appointments Clause. Without “a split in the Circuit Courts”, timely review by the U.S. Supreme Court becomes less likely.
DOL proposes 18-month delay of effectiveness date for remaining provisions of fiduciary rule exemptions
On August 31, 2017, the Department of Labor (DOL) published in the Federal Register a proposal to delay from January 1, 2018 to July 1, 2019 the effectiveness date for the remaining conditions of the “Best Interest Contract” Exemption, Principal Transactions Exemption, and Prohibited Transaction Exemption 84-24 for Annuities of its Fiduciary Rule. The proposal seeks public comment on the structure and duration of the delay, as well as an extension of the temporary enforcement policy which is currently in place. The DOL has requested comments by September 15, 2017.
On August 30, 2017, the DOL issued Field Assistance Bulletin 2017-03 announcing the DOL’s enforcement policy for the arbitration provisions of the BIC Exemption and Principal Transactions Exemption. The DOL stated that it will not pursue a claim against a fiduciary based on a fiduciary’s failure to satisfy the arbitration provisions of these exemptions.
In U.S. v Martoma, Second Circuit eliminates “meaningfully close personal relationship” element articulated in Newman for insider trading prosecutions
On August 23, 2017, the U.S. Court of Appeals for the Second Circuit issued a ruling in the case of U.S. v Martoma, upholding the 2014 conviction of former S.A.C Capital Advisors trader Mathew Martoma for securities fraud and insider trading. The Second Circuit ruling refers to several earlier landmark cases in the evolving jurisprudence regarding insider trading, including U.S. v Newman, upon which Martoma had drawn heavily in his defence. In the view of the Second Circuit, the Supreme Court’s ruling in Salman v U.S. supersedes and repudiates certain of Newman’s highly specific requirements to establish insider trading violations, including Newman’s “meaningfully close personal relationship” criterion. The ruling in Martoma is significant for investment advisers and traders because it weighs the differing legal standards under Newman and Salman and affirms a significantly lower bar for pursuing insider trading charges. This marks a decisive shift in a body of jurisprudence around insider trading that has evolved in numerous directions since the landmark 1983 ruling in Dirks v SEC.
The Market Abuse Regulation – not just an EU compliance issue
Author: Simon Lovegrove
In this short article we discuss the extra territorial aspects on the EU Market Abuse Regulation.
The EU Market Abuse Regulation (MAR) came into effect on July 3, 2016. It replaced the EU Market Abuse Directive (MAD) and contains rules on insider dealing, unlawful disclosure of inside information and market manipulation that apply throughout the EU.
In addition, the prohibitions and requirements set out in MAR apply to acts or omissions that occur in a third country like the United States.
The extra-territorial application of the EU market abuse regime is nothing new: MAD previously had extra-territorial effect and EU Member State regulatory authorities pursued enforcement action against individuals and firms who had committed market abuse from outside their jurisdiction. However, the implementation of MAR was an important moment for the EU market abuse regime on the basis that it significantly expanded the types of financial instrument that come within the regime and sets out more detailed compliance requirements.
Under MAD the market abuse regime covered ‘financial instruments’ that were admitted to trading on EU “regulated markets”, such as the main market of the London Stock Exchange. The range of instruments that were caught by the definition of ‘financial instrument’ included transferable securities (covering shares in companies and other securities equivalent to shares in companies, bonds and forms of securitised debt), certain types of futures, forward agreements, swaps, options and derivatives.
However, under MAR the scope of financial instruments has been significantly expanded. The market abuse regime covers not only financial instruments traded on an EU regulated market but also financial instruments traded on a multilateral trading facility (MTF) and organised trading facility (OTF). MTFs encompass many broker-operated trading venues and listing venues that are not regulated markets, such as the Irish Global Exchange Market and the Luxembourg EuroMTF. OTFs are a new type of trading venue that has been created by the revised Markets in Financial Instruments Directive (known as MiFID II) for the trading of non-equity instruments such as bonds and derivatives. MiFID II comes into force on 3 January 2017 and, importantly, reclassifies emission allowances as a ‘financial instrument’ which will also fall within the scope of MAR.
It is also worth noting that the market abuse regime under MAR applies to financial instruments whose price or value depends on or has an effect on the price or value of a financial instrument traded on a EU trading venue (regulated market, MTF or OTF) . This includes, but is not limited to, credit default swaps and contracts for difference. Furthermore, for the purposes of the market manipulation offence, spot commodity contracts (which are not wholesale energy products) are caught in certain circumstances as well as other financial instruments including derivative contracts/instruments which transfer credit risk, where the transaction or behaviour has an effect on the price or value of a spot commodity product. The manipulation offence also extends to conduct in relation to benchmarks.
By expanding the scope of financial instruments it is much easier for non-EU firms to be caught by the EU market abuse regime. Take for example the following scenario:
- US company ‘A’ trades with US counterparty ‘B’ in the shares of US issuer ‘C’;
- US issuer ‘C’ shares are listed on the New York Stock Exchange (NYSE);
- The trades occur on the NYSE;
- US issuer ‘C’ website refers solely to the NYSE listing;
- US issuer ‘C’ shares also admitted to trading on an MTF in London; and
- US company ‘A’ and US company ‘B’ will be subject to MAR, since US issuer C’s shares are also traded on the London MTF, even though trading between the two US entities occurs solely on the NYSE.
The need for non-EU market participants to have the necessary systems in place to monitor forensically the instruments they trade has become ever more important. To some extent firms will be assisted by the European Securities and Markets Authority which is required under MAR to publish a consolidated list of financial instruments that are admitted to trading or are otherwise traded on all EU trading venues. However, this list has been delayed until the implementation of MiFID II. Notwithstanding this, MAR further provides that ESMA’s consolidated list should not be treated as exhaustive so there should be some caution when relying on it.
When compared to MAD, MAR also sets out much more detailed compliance requirements including those relating to market soundings, disclosure of inside information, insider lists, market surveillance, suspicious transaction reporting and investment recommendations. Integrating the MAR requirements into the compliance framework has been a significant challenge for non-EU firms although this is important when they are engaging in activities that bring them within scope of the requirements.