On July 23, 2024, the U.S. Court of Appeals for the D.C. Circuit reversed the U.S. Tax Court in holding that inventory gain recognized by a nonresident alien individual partner on the sale of her interest in a U.S. partnership was not taxable as U.S. source income. 

The taxpayer in Rawat is a Canadian citizen that owned 29.2% of a U.S. partnership, Innovation Ventures LLC (“Innovation”).  Innovation markets and sells 5-Hour Energy drinks. In 2008, the taxpayer sold her partnership interest in exchange for a promissory note worth approximately $438 million.  At the time of the sale, Innovation held inventory valued at $6.4 million, which it later sold for a profit of $22.4 million.  The IRS argued that the taxpayer should be taxed as if $6.4 million (i.e., 29.2% of $22.4 million) of the partnership interest sale was instead deemed a hypothetical sale of Innovation’s inventory.  The Tax Court agreed with the IRS in holding that Internal Revenue Code Section (“Section”) 751(a) permits the treatment of the sale of a partnership interest as a deemed sale of the partnership’s hot assets (i.e., inventory and unrealized receivables) for purposes of Section 865(b)’s sourcing rules.  Thus, the Tax Court held that the taxpayer’s deemed inventory gain was U.S. sourced income subject to U.S. federal income taxes. 

In reversing the Tax Court, the D.C. Circuit looked to the statutory language of Section 751(a) in conjunction with Section 741 in holding that Section 751(a) does not permit the treatment of a partnership interest sale as a hypothetical sale of the partnership’s hot assets.  Rather, Section 751(a) converts the taxpayer’s gain on the sale of their partnership interest from capital gain to ordinary income.  Because Section 751(a) does not permit treating the taxpayer’s partnership interest sale as a hypothetical sale, her gain attributable to Innovation’s inventory was not subject to U.S. federal income tax. 

Because Congress amended Section 864 as part of the Tax Cuts and Jobs Act, the D.C. Circuit’s holding is relevant to foreign partners that sold partnership interests before November 27, 2017.  For foreign partners currently under audit, Rawat provides clear guidance as to the proper interpretation of Section 751(a).  However, it is unclear if the IRS will continue to take the same position in cases outside of the D.C. Circuit as it did in Rawat.  At Fox Rothschild, we represent foreign investors in a variety of ways, including in tax matters, and are ready, willing, and able to provide assistance with any IRS tax matters on request.

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