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Answering the Right Question in Rawat

Posted on Mar. 18, 2024
Reuven S. Avi-Yonah
Reuven S. Avi-Yonah

Reuven S. Avi-Yonah (aviyonah@umich.edu) is the Irwin I. Cohn Professor of Law at the University of Michigan Law School. He thanks Kimberly S. Blanchard, Robert Goulder, and Monte A. Jackel for their helpful comments.

In this installment of Reflections With Reuven Avi-Yonah, Avi-Yonah redirects discussion of Rawat to international tax issues, arguing that the problem in the case stems from a lack of coordination between sections 741 and 751 and section 865.

The Rawat case, which is currently before the D.C. Circuit, has generated a huge amount of commentary.1 The problem is that much of this commentary has focused on the partnership tax issues in the case and not on the international tax issue, which is the source of the relevant income. In my opinion, the international tax issue should be dispositive.

The case involves Indu Rawat, a Canadian citizen residing in Singapore who acquired a 30 percent interest in Innovation Ventures LLC, a U.S. partnership that controls the maker of the popular 5-Hour Energy line of beverages. In 2008 Rawat sold her partnership interest to Manoj Bhargava, a U.S. citizen and the founder of Innovation Ventures.

Under section 741, the sale is considered to be a sale of the partnership interest, not of the partnership assets. But under section 751(a), some of the gain from such a sale may be treated as ordinary income if it is attributable to so-called hot assets, such as inventory. When Rawat disposed of her stake in Innovation Ventures in 2008, the business held inventory items with a basis of $6.4 million. The inventory was later sold for $22.4 million. Section 751(a) treats the portion of the sale proceeds attributable to the inventory as “an amount realized from the sale or exchange of property other than a capital asset.”

This result is a combination of treating the partnership as an entity (section 741) and as an aggregate (section 751). Before subchapter K was enacted in 1954, partnerships were generally treated as aggregates, but Congress determined that the mixed approach is better.2

Because Rawat is a foreign resident, the sale generally would fall under the source rule of section 865(a)(2), which sources capital gains to the country of residence of the seller. The rule’s rationale is that it is hard to enforce a withholding tax on sales of personal portfolio assets such as stock from one foreigner to another. I have argued elsewhere that this administrative rationale should not apply to the sale of large participations in a U.S. corporation or partnership because, in those cases, the buyer would want to register the acquired assets in its name (for example, for voting purposes). Therefore, even if the buyer and seller are foreign, it is possible to tax the transaction, just like the sale of U.S. real estate and shares in companies holding U.S. real estate is currently taxed as effectively connected to a deemed U.S. trade or business under section 897.3 Under that rule, Rawat’s sale would be taxable because she sold 30 percent of the interest in the partnership.

But that is not the law now, and in Grecian Magnesite, the Tax Court held that a sale of a partnership interest by a nonresident was not subject to U.S. tax, and this result was upheld on appeal.4 This outcome was promptly overturned by Congress when it enacted section 864(c)(8), but that legislative change does not apply retroactively. Although the Grecian Magnesite facts did not involve section 751 income (and the Tax Court specifically reserved on the point), Rawat argues on the basis of the case that she is not liable for U.S. tax on her gain from the sale, but the IRS disagrees and argues that she is responsible for U.S. tax on the $6.5 million of gain from the sale that was attributable to the gain on the inventory.

The IRS position in Grecian Magnesite was based in part on Rev. Rul. 91-32, 1991-1 C.B. 107, which held that gains realized when a foreign partner disposed of a partnership interest are effectively connected income and subject to U.S. tax if the partnership was engaged in a trade or business in the United States. The partner did not have to be separately engaged in a U.S. trade or business for this rule to apply. If a treaty applied, the ruling declared that the foreign partner’s gains were to be considered attributable to a U.S. permanent establishment. That is the result adopted by Congress in 2017 under section 864(c)(8).

In a case of first impression, the Tax Court in Rawat held for the IRS.5 It concluded that the governing rule for section 751 income attributable to inventory held by a partnership is not the general rule of section 865(a) but the exception in 865(b), which states that “in the case of income derived from the sale of inventory property . . . such income shall be sourced under the rules of sections 861(a)(6), 862(a)(6), and 863,” which results in U.S.-source income. That is the issue currently on appeal to the D.C. Circuit. Oral arguments were heard in February.6

The key question is not the partnership rules but the source rules of section 865. Several issues come to mind on the issue of the source of the sale of the partnership interest in Rawat.

First, source rules start from characterization, and for that, one must look outside the source rules: in this case to section 751.7 Section 751(a) says the amount realized by the seller of a partnership interest regarding section 751 property is considered to be from the sale or exchange of property other than a capital asset. That statute refers to the items that trigger it, which includes inventory. This explicit and perhaps unique statutory formulation addressing the intersection of entity and aggregate treatment of a partnership interest in subchapter K is informed by relevant legislative history.8 The section 751 regulations, which reflect the legislative history, are clear that the amount of section 751(a) gain of the relevant partner is determined by reference to the tax basis in the inventory of the partnership, and they envision a constructive sale to determine the amount.9 Thus, the section 751 inclusion of the seller is directly attributable to (in this case) a constructive sale of the inventory. (This does not mean that deemed sale treatment applies to the partnership, the acquiring partner, or anyone other than the selling partner, but our only concern in Rawat is the taxation of the selling partner.) The fact that a characterization provision may have consequences for other purposes has section 751 precedent in domestic settings in the Mingo and Quick Trust cases.10

Second, section 865(b) refers to a “sale,” but that means an “exchange or any other disposition” under section 865(i)(2). The term “disposition” has been broadly construed elsewhere and could include an indirect disposition through a partnership even if the partnership is not otherwise viewed as an aggregate.11

Third, a disposition that is considered or deemed to occur for tax purposes is given the same effect as one that has occurred in fact. To the extent there is statutory ambiguity, the source rules and case law determining source by analogy look to the economic nexus of the taxing jurisdiction, which in this case is to the United States.12

Finally, regarding taxation, partnership allocations of sales by the partnership to the taxpayer-partner are treated as effectively connected with a U.S. trade or business via section 875 if the partnership was so engaged and if the income is ordinary income and U.S.-source it is automatically effectively connected per section 864(c)(3).

For these reasons, the court of appeals should affirm.

This whole complicated set of issues reminds me of another case in which the interaction of the partnership rules and the international rules led to a confusing outcome. In Brown Group, the taxpayer was a U.S. corporation that controlled a subsidiary in the Cayman Islands, which was a controlled foreign corporation.13 The CFC bought shoes in Brazil and resold them to the parent, which resold them to customers in the United States. If that were all, the base company rule of section 954 would clearly have triggered a deemed dividend to the U.S. parent because the shoes were sold by a CFC to a related party outside the CFC’s country of incorporation and were not modified by the CFC in any way.

However, for nontax reasons, the sale and resale of the shoes were made through a Caymans partnership that was 88 percent owned by the CFC. Thus, the issue was whether the CFC’s distributive share of partnership income was still base company income in the hands of the CFC, which involves the same aggregate versus entity issue that lies at the heart of Rawat.

At the Tax Court in Brown Group, Judge Julian I. Jacobs originally held for the taxpayer. He reasoned that section 702(a) lists items that keep their character when they become a distributive share, but that list does not include base company income, which therefore is subject to the default rule of section 702(a)(7), which at that time referred to items that affect the taxation of the relevant partner. But the relevant partner was the CFC, not the U.S. parent, and the CFC was not subject to U.S. tax. Therefore, the entity approach prevailed, and the characterization did not flow through from the partnership to the CFC.

This holding, however, created a loophole in subpart F that you could drive a truck through: It would be enough for any two CFCs of the same U.S. parent to form a foreign partnership and route their base company income through the partnership to exclude that income from subpart F. Therefore, when the Tax Court sitting en banc reviewed the case, the majority held for the government. There were many reasons given, but none of them is persuasive. On appeal the taxpayer prevailed on a completely new argument, which was that, in the tax year in question, the partnership and the CFC were not considered related parties. The reason the court of appeals adopted this view was because Congress by then had changed the definition so that a CFC was considered related to a partnership it controls, but that definition was irrelevant because the issue is not whether the partnership had base company income (it could not because it is not a CFC) but whether it should be treated as an aggregate for subpart F purposes. Eventually the problem was fixed by changing the regulations under 954 (the section 702 rule was changed later).

The basic problem in Brown Group was the lack of coordination between section 702 and section 954. When Congress enacted section 702 in 1954, it clearly could not have taken section 954 into account because that section was only enacted in 1962. While it would have been good to modify section 702 to address section 954 in 1962 (or to modify section 954 to address section 702), in those pre-check-the-box days, the partnership tax bar was sadly ignorant about international tax issues (and vice versa).

The better fix for the Brown Group problem would have been to abandon the deemed dividend approach to subpart F and instead treat the U.S. shareholder as earning subpart F income directly, as if the CFC were a partnership for that purpose. That is what other countries that adopted CFC rules after the United States have done. None of them relies on deemed dividends, but the United States persisted in following this approach in the global intangible low-taxed income regime.14 Similarly, the problem in Rawat stems from a lack of coordination between sections 741 and 751 on the one hand and section 865 on the other.

These examples show that it is important not to leave partnership taxation just to the partnership tax bar. Partnership tax rules have implications for both subchapter C and subchapter N, and it behooves tax practitioners, academics, and policymakers that specialize in these areas to be knowledgeable about subchapter K as well. Perhaps that would lead to better results in a case like Rawat, in which the partnership tax bar has been critical of the government position.15

FOOTNOTES

1 Rawat v. Commissioner, T.C. Memo. 2023-14, appeal docketed, No. 23-1142 (D.C. Cir. June 5, 2023). See, e.g., Robert Goulder, “The Rawat Litigation: A Hot Take on the Hot Assets Rule,” Tax Notes Int’l, May 29, 2023, p. 1279; and Goulder, “The Rawat Litigation, Part 2: Everything Old Is New Again,” Tax Notes Int’l, Feb. 26, 2024, p. 1215; Kimberly S. Blanchard, “Hot Assets, Source, and Hypothetical Rules: How the Rawat Court Made Hash Out of Simple Rules,” Tax Notes Int’l, Mar. 11, 2024, p. 1429.

2 See Willams v. McGowan, 152 F.2d 570 (2d Cir. 1945), a wonderfully written opinion by Judge Learned Hand treating a sale of 100 percent interest in a partnership as the sale of its assets for characterization purposes. For a discussion of aggregate versus entity, see Monte A. Jackel, “Aggregate-Entity Redux,” Tax Notes Federal, May 8, 2023, p. 1029.

3 Reuven S. Avi-Yonah, “Money on the Table: Why the U.S. Should Tax Inbound Capital Gains,” Tax Notes Int’l, July 4, 2011, p. 41.

4 Grecian Magnesite Mining, Industrial & Shipping Co. SA v. Commissioner, 149 T.C. 63 (2017), aff’d, 926 F.3d 819 (D.C. Cir. 2019).

5 Rawat, T.C. Memo. 2023-14.

6 See Kristen A. Parillo, “Oral Argument in Rawat Focuses on Definition of Ordinary Income,” Tax Notes Int’l, Feb. 12, 2024, p. 935.

7 See the multiple cases in which the characterization of the income determines the source and therefore whether the income is taxable, such as Commissioner v. Wodehouse, 337 U.S. 369 (1949) (royalties versus capital gain); Karrer v. United States, 152 F. Supp. 66 (Ct. Cl. 1957) (royalties versus services); Boulez v. Commissioner, 83 T.C. 584 (1984) (royalties versus services); Bank of America v. United States, 680 F.2d 142 (Ct. Cl. 1982) (interest versus services); Garcia v. Commissioner, 140 T.C. 141 (2013) (allocating a professional golfer’s endorsement income 65 percent to image rights and 35 percent to personal services and concluding that only the U.S.-source personal services income was subject to U.S. tax); Goosen v. Commissioner, 136 T.C. 547 (2011) (allocating professional golfer’s endorsement income between royalties for use of his name and image and personal services income, and further sourcing the income between U.S. and foreign sources). See also AM 2009-005.

8 See H.R. Rep. No. 83-1337, at 71 (1954). See also S. Rep. No. 83-1622, at 99 (1954): “The statutory treatment proposed, in general, regards the income rights as severable from the partnership interest and as subject to the same tax consequences which would be accorded an individual entrepreneur.” Note that the legislative history accompanying the later enactment of section 751(f) is consistent. See H.R. Rep. No. 98-432, at 1229 (1984); see also S. Prt. No. 98-169, at 240 (1984): “Section 751 will be applied by regarding income rights, as section 751 does under present law, as severable from the partnership interest. Under this approach, a partner will be treated as disposing of such items independently of the rest of his partnership interest.”

9 Reg. section 1.751-1(a)(2) and (g) (example 1). As the example illustrates, section 751 does not merely recharacterize gain from a partnership interest as ordinary but recasts the transaction for federal income tax purposes such that section 751 (ordinary) income displaces section 741 capital gain or loss and can result in the selling partner having a capital loss rather than gain or a greater capital loss.

10 Mingo v. Commissioner, T.C. Memo. 2013-149, aff’d, 773 F.3d 629 (5th Cir. 2014); George Edward Quick Trust v. Commissioner, 54 T.C. 1336 (1970), aff’d per curiam, 444 F.2d 90 (8th Cir. 1971).

11 Section 865(i)(5) says that in the case of a partnership, the section applies at the partner level, meaning that a partnership sale is treated as made by the partners, changing the initial rule, which looked to the status of the partnership as foreign or domestic in determining source on the sale by the partnership. A reasonable construction of “disposition” of property has included the disposition of an entity containing the property. See, e.g., reg. section 1.367(d)-1T(a) (construing “disposition” in section 367(d)(2)(A)(ii)(II)); reg. section 1.1411-10(c)(2)(iii) (construing “disposition” in section 1411(c)(1)(A)(iii)); and prop. reg. section 1.1291-3(a) (construing “disposition” in section 1291(a)(2) and (e)(2)). See also Aeroquip-Vickers Inc. v. Commissioner, 347 F.3d 173 (6th Cir. 2003); Walt Disney Inc. v. Commissioner, 4 F.3d 735 (9th Cir. 1993) (citing Salomon Inc. v. United States, 976 F.2d 837 (2d Cir. 1992); Rev. Rul. 82-20, 1982-1 C.B. 6).

12 See, e.g., Korfund Co. v. Commissioner, 1 T.C. 1180 (1943).

13 Brown Group Inc. v. Commissioner, 77 F.3d 217 (8th Cir. 1996), vacating and remanding 104 T.C. 105 (1995). The case was tried before Tax Court Judge Julian I. Jacobs, who filed an opinion in favor of the taxpayer. Brown Group v. Commissioner, 102 T.C. No. 24 (1994). The IRS moved for reconsideration and the case was resubmitted to the entire Tax Court. Without further briefing or argument, the Tax Court ordered that decision be entered for the IRS on January 25, 1995. 104 T.C. 105.

14 See Avi-Yonah, “The Deemed Dividend Problem,” 4 J. Tax’n Global Transactions 33 (2004).

15 Parillo, “Tax Pros Skeptical of DOJ Argument on Aggregate Theory in Rawat,” Tax Notes Int’l, Nov. 13, 2023, p. 1023.

END FOOTNOTES

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