Background

Before 2017,¹ section 741 provided that gain/loss from the sale/exchange of a partnership interest is generally treated as a capital gain/loss. Section 751 provided an express exception to that general capital gain treatment for gain attributable to either unrealized receivables or inventory items of the partnership, such that the attributable gain would be taxed as ordinary income. As to determining whether such income was foreign or US sourced, pre-2017, there was no specific sourcing rule that governed income arising from the disposition of a partnership interest. Instead, the rules governing the sale of personal property controlled. Under those rules, income from a non-resident alien’s sale of personal property generally was treated as foreign-source (and non-taxable) (see section 865(a)(2)), but income from a non-resident alien’s sale of inventory could be US-source (and taxable) (see sections 861(a)(6), 862(a)(6), 865(b)).

In 1991, the IRS issued Revenue Ruling 91-32, which held that a non-US partner’s gain on the sale of a partnership is effectively connected income (ECI), and therefore is subject to US federal income tax, to the extent the gain is attributable to the partnership’s US trade or business (USTB). On July 13, 2017, the Tax Court in Grecian Magnesite Mining, Indus. & Shipping Co., SA, v. Commissioner, 149 T.C. 63 (2017), declined to follow Revenue Ruling 91-32, and instead held that the non-US partner’s gain from the disposition of a partnership interest was not subject to US federal income tax as ECI except with respect to the portion of the gain attributable to the partnership’s US real property interests. The court noted that generally the sale of a partnership interest is treated as the sale of a single capital asset that precludes looking through to the individual assets of the partnership. But the court acknowledged that the general rule was subject to exceptions explicitly carved out by Congress—such as in sections 751 and 897(g)—which authorize looking through to the partnership assets in limited circumstances. The D.C. Circuit affirmed the Tax Court decision but did not address the implications of section 751.²

Rawat case

The D.C. Circuit’s opinion in Rawat v. Commissioner,³ now clarifies the Grecian holding. Indu Rawat was a non-resident alien who had a 29.2% interest in a US partnership. In 2008, Rawat redeemed her partnership interest in exchange for a promissory note worth approximately USD 438 million, of which USD 6.5 million was attributable to gain on the partnerships’ sale of inventory later that year (“Inventory Gain”). Both Rawat and the IRS agreed that the character of the Inventory Gain was ordinary.

At issue, however, was the source of the Inventory Gain (US-source or foreign-source), and whether Rawat, as a non-resident alien, was subject to US tax on that gain. The IRS took the position that the Inventory Gain was US-source taxable income. Rawat paid the taxes and petitioned in Tax Court for a refund. In a motion for summary judgment Rawat argued that the entire proceeds of the sale (including the Inventory Gain) were treated under section 741 as gain from the sale of a capital asset and further treated as income from the sale of personal property under section 865(a)(2), and therefore constituted non-US-source income not subject to US tax. At bottom, the taxpayer argued that section 741 merely characterized a portion of the gain arising from the sale of a partnership interest and attributable to the partnership’s inventory as ordinary income, but the entirety of the gain was still from the sale of a single capital asset, and thus foreign-sourced. Alternatively, the Commissioner argued that section 741 went further – characterizing the Inventory Gain as arising from a distinct deemed sale of inventory, thus US-sourced.

The Tax Court denied Rawat’s motion for summary judgment and concluded that while section 741 provides that the sale of a partnership interest is a sale of a single capital asset, section 751(a)(2) excepts the partnership interest attributable to inventory or unrealized receivables as property other than a capital asset such that it must be separately sourced. The court explained that sections 741 and 751 determined the nature of the property sold and the nature of the income (as capital or ordinary). Sourcing must then be applied to such determinations. Accordingly the Inventory Gain was excepted from the general sourcing rule for the sale of personal property and instead subject to the specific sourcing rules for income derived from the sale of inventory property (which required analyzing whether the source of the Inventory Gain was within the United States).⁴

On appeal, the D.C. Circuit reversed the Tax Court decision, and treated the entirety of the gain from the disposition of the partnership interest as foreign-source. The D.C. Circuit rejected the Tax Court determination that section 751 operated as a sourcing rule such that gain from the disposition of a US partnership interest attributable to inventory could be sourced to the United States as if it was income arising from the sale of inventory. The court held that section 751 like section 741 only addressed the character of the gain (as capital gain or ordinary income), and did not otherwise disturb the asset characterization of the partnership interest (by transforming a portion into the sale of inventory). In reaching this conclusion, the court engaged in an independent and robust statutory analysis. The court focused on the key clause of section 751(a), which stated that gain “shall be considered as an amount realized from the sale or exchange of property other than a capital asset,” and tied this clause to the operative language of section 64 that mandates the ordinary income treatment of “any gain from the sale or exchange of property which is neither a capital asset nor property described in section 1231(b).” The court further considered the language of section 741, finding that, collectively, sections 741 and 751 were interlocking provisions comparable in scope and effect that narrowly specified the treatment of gain as ordinary or capital. The court further bolstered its statutory analysis by looking to the legislative history of section 751, the agencies’ own regulations which equally supported Rawat’s interpretation of the statute, and the Commissioner’s acquiescence of the decision by the Tax Court in Grecian Mining.

Take-aways

Specifically, the D.C. Circuit’s decision in Rawat provides clarity on sourcing rules for pre-TCJA dispositions of partnership interests. More broadly, the decision reflects a robust statutory analysis where the court, consistent with the mandate in Loper Bright Enters. v. Raimondo, 144 S. Ct. 2244 (2024), exercised its independent judgment to interpret and give effect to the best meaning of the statute.

1 In 2017, Congress enacted a straightforward sourcing rule under section 864(c)(8). See Tax Cuts and Jobs Act of 2017 (TCJA), Pub. L. No. 115-97, 131 Stat. 2054. Post-2017, when a non-resident alien sells an interest in a US partnership, income from the sale is US-source (and hence taxable). See section 864(c)(8).
2 See Grecian Magnesite Mining, Indus. & Shipping Co., SA v. Commissioner, 926 F.3d 819 (D.C. Cir. 2019).
3 Rawat v. Commissioner, 108 F.4th 891 (D.C. Cir 2024).
4 See Rawat v. Commissioner, T.C. Memo. 2023-14.