The US Partnership Taxation Issue

Taxation is obscure. Partnership taxation is really obscure. 70% of partnership income accrues to the top 1% of taxpayers, but over 50% of all business income is earned through partnerships (or other pass-through entities). It is fair to say its revenue impact is disproportionate to its relevance in an existential sense.

Taxation Conundrum 

The only reason to bring this to anyone’s attention is that a recent case in the United States Tax Court – not usually the most taxpayer-friendly forum – has overturned a quarter century of IRS practice and is going to trigger much head-scratching in the Hamptons and lead to many hours of billable time in the tax community.

The essence of the issue is as follows: investors (foreign investors for the purposes of this article) love to invest in the US capital markets.

At $18trn of GDP, it is hard to avoid the US entirely in any asset allocation strategy. Ideally, foreign investors would like not to pay tax in the United States, preferring to pay tax in their home country. There are many opportunities to legitimately avoid US taxation.

Hedge Fund Investing

One area where this is challenging is investing in hedge funds. Hedge funds are often structured as partnerships. Partnerships offer their partners the benefit of suffering no taxation at the level of the partnership. Corporations do not offer this benefit: corporations in the US pay tax, passing on already taxed income to their shareholders in the form of dividends which then suffer an additional level of tax in the hands of the shareholders. Usually, therefore, investors prefer partnership taxation.

Foreign investors, however, do not, because they are deemed, as partners, to be actively involved in the business of the partnership even though they are passive investors. This feature of partnership taxation gives foreign investors what is referred to as effectively connected income (ECI) and means they must file a US tax return.

Avoiding Taxation

To avoid ECI, hedge funds and their foreign investors go to great lengths and interpose so-called blocker corporations to break the connection between the investors and the underlying business, restoring foreign investors to their passive status for tax purposes. These blocker corporations are frequently situated in tax-haven jurisdictions to avoid the friction of an extra level of taxation.

Not all foreign partners are able to structure their affairs in this way. In this case, the foreign partner suffered ECI in respect of its current income earned and distributed while it was a partner. When it exited the partnership, however – it was redeemed out in two stages – it took the position that it had sold its position in an entity and that gain on redemption was capital, non-ECI and, therefore, not taxable in the US.

The IRS, on the other hand, took the position that the foreign partner had, under the tax fiction that it had, in effect, sold its share of the partnership’s underlying assets, realised ECI on the gain and was taxable in the US. This, in fact, was the argument that the IRS set out in its 1991 Revenue Ruling 91-32.

Administrative Rulings – Theory and Practice

Revenue rulings are administrative rulings by the IRS applying the law to particular factual situations. They may be relied on as precedent by taxpayers, are binding upon revenue agents and IRS officials, but are given less deference by the courts than tax regulations. In this case, the Tax Court thought the ruling poorly reasoned and chose not to give it deference. The case is far from trivial and has overturned over 25 years of practice.

The theory behind the court’s reasoning is sound, though, and will give practitioners reason to revisit some of the structuring surrounding the need for blocker corporations. The history of the active trade or business definition that leads to ECI is a long one and involves some lobbying by banks. The mere holding of stocks and bonds is not something that triggers active status. Actually making loans, however, is: banks did not want to allow foreign banks to be in the business of making loans to US borrowers without also being subject to US taxation. 

The Opportunity

Current practice for hedge fund managers is to avoid using blockers when they can by threading the needle on whether foreign investors (tax exempt investors have similar concerns but for different reasons) are deemed to have ECI by ensuring that the partnership itself if not engaged in an active US trade or business. It ought to be possible for passive investors in partnerships to avoid ECI simply because they are passive investors.

This is where the recent case creates opportunity by now highlighting something of an inconsistency. If a foreign investor is not considered to generate ECI in a domestic US partnership by reason simply of buying and selling its interest in the partnership, is this not properly a reflection of its passive status and should this not also be applied to the income and distributions it earns while it is a partner?

If the answer to that question is “yes”, then the need for a blocker corporation to shield foreign partners from ECI would appear to disappear. The story, clearly, is not over and hedge fund managers would be well advised to hold the celebrations for now.

It would not be hard for the IRS to rethink its position, appeal the case, or simply issue another administrative document – Revenue Ruling or Notice – and thereby create another 25 years of uncertainty.