In more detail

Section 897(a) generally requires a nonresident alien individual or a foreign corporation to treat its gain or loss from disposing of a US real property interest (USRPI) as income effectively connected with the conduct of a US trade or business (ECI). Stock in a USRPHC generally constitutes a USRPI, but under section 897(c)(3), a class of stock that is regularly traded on an established securities market is treated as a USRPI only with respect to a person who has held more than 5% of that class of stock at some point during a relevant holding period. For purposes of calculating the 5%, the constructive ownership rules of section 318(a) apply (except that stock owned by a corporation is attributed upwards to its shareholders, and stock owned by a shareholder is attributed downwards to a corporation, only if the shareholder holds at least 5% of the stock of the corporation). In particular, section 318(a)(2)(A) provides that stock owned, directly or indirectly, by a partnership is treated as owned proportionately by its partners. The statute is silent, however, on whether section 897(c)(3) applies with respect to a partner who constructively owns less than 5% of the stock of a USRPHC, but does so through a partnership which owns more than 5% of the stock of the USRPHC.

The advice considers two scenarios in which NRA, a nonresident alien individual, owns a 25% interest in the capital and profits of PRS, a partnership, which in turn holds stock of CORP, a USRPHC whose stock is regularly traded on an established securities market. In Situation 1, PRS holds 8% of the stock of CORP and disposes of all of its CORP stock, recognizing gain, which PRS allocates proportionately among its partners, including NRA. In Situation 2, PRS holds 4% of the stock of CORP, while NRA holds an additional 4.5% of the stock of CORP directly. NRA disposes of, and recognizes gain on, all of the CORP stock that it holds directly. The issue in each situation is whether NRA’s gain on the disposition of its CORP stock is treated as ECI, or, conversely, whether the regularly traded stock exception of section 897(c)(3) applies.

The IRS concluded that NRA recognizes ECI in both situations. First, because the 5% ownership threshold of section 897(c)(3) applies to a “person” and a “person” generally includes a partnership pursuant to section 7701(a)(1), the threshold should apply at the partnership level unless it is more appropriate to treat the partnership as an aggregate of its partners in carrying out the purposes of this particular provision. The IRS noted that when determining whether a partner’s share of a partnership’s income is subject to US tax based on nexus, nexus is generally determined at the partnership level. For example, section 875(1) imputes the US trade or business of a partnership to its partners based on the partnership’s activities (nexus), requiring any foreign partners of a partnership that is engaged in a US trade or business to file US tax returns even if they themselves are not directly engaged in a US trade or business. According to the IRS, it would be consistent with such treatment to require foreign partners of a partnership that exceeds the 5% ownership threshold of 897(c)(3) to file US tax returns even if they themselves do not exceed the 5% ownership threshold. Furthermore, the IRS reasoned, a partnership should have no more difficulty in determining whether or not a corporation is a USRPHC than its partners would have if they invested directly in the corporation. Therefore, section 897(c)(3) applies at the partnership level when a partnership holds stock directly in a USRPHC.

In Situation 1, PRS holds more than 5% of CORP stock, so the CORP stock is a USRPI with respect to PRS’s foreign partner, NRA, and the gain allocated to NRA by PRS is treated as ECI. It does not matter that NRA indirectly owns only 2% of CORP stock because the 5% threshold applies at the level of PRS, which is a “person” in its own right for purposes of section 897(c)(3).

In Situation 2, NRA holds 4.5% of CORP stock directly and constructively holds 1% (= 4% * 25%) of CORP stock, for a total of 5.5%. Because NRA is treated as holding more than 5% of CORP stock, the regularly traded stock exception does not apply and all of the CORP stock is a USRPI in NRA’s hands. Therefore, the gain NRA recognizes on the disposition of its directly-held CORP stock is treated as ECI.

There is less ambiguity with respect to the outcome of Situation 2, which appears to illustrate the straightforward application of the way that the constructive ownership rules apply the 5% ownership threshold at the partner level. One may have thought that the application of the constructive ownership rules itself implies that the 5% ownership threshold is a partner level determination and not a partnership level determination. Apparently, the IRS sees no such implication and has asserted that the 5% ownership threshold applies at both the partner and partnership levels.