An appeals court decision could help financial advisors answer foreign clients' tax questions about selling their U.S. partnership holdings at a massive profit.
Foreign businesswoman Indu Rawat did not owe the IRS the $2.3 million she paid in taxes for what the agency deemed to be an "inventory gain" of $6.5 million out of the $438 million that she received for her large minority stake in the parent firm of the company that owns 5-Hour Energy drink, according to the D.C. Circuit Court decision last month. The ruling reversed a Tax Court decision that found she earned income from the sale of inventory when she sold her holdings in the company and resolved a saga that started after the transaction 16 years ago.
Today, the rules of the Tax Cuts and Jobs Act of 2017 require the taxation of any income earned from a U.S. investment or another source of money based in the country, noted Brian Harvel, an Atlanta-based partner with the
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The appeals court decision provided a reminder to advisors and other industry professionals that foreign clients should "invest through a corporate blocker" rather than directly or into partnerships or other pass-through entities "because they do not want to obtain an [individual taxpayer identification number], prepare U.S. tax returns, or pay U.S. taxes," Harvel said in an email. The ruling took a different position from the Tax Court's view that the several millions of dollars worth of proceeds came from a U.S. income source rather than a foreign one, he said.
"The Tax Court held the former, while the D.C. Circuit Court held the latter," Harvel said. "If the former, the source rules for the sale of inventory items would apply, and the recharacterized ordinary income would come from U.S. sources. If the latter, the source rules for the sale of personal property (the partnership interest) would apply, the recharacterized ordinary income would come from foreign sources."
The case hinged on the definition of "inventory" and whether the transaction constituted the sale of inventory. The IRS read the relevant provision of the Tax Code to treat "gain on the sale of a partnership interest attributable to inventory to be gain on the sale of inventory, such that it can be taxable as U.S.-source income," Chief Judge Srikanth Srinivasan wrote in the opinion. Rawat's lawyers contended that the section "has a more limited scope" that "does not give rise to a deemed sale of inventory and thus does not render taxable what would otherwise be nontaxable income," Srinivasan said.
"Rawat considered the inventory gain she realized to be nontaxable, as it arose from the sale of a partnership interest, not from the actual sale of inventory," he added. "Accordingly, she maintained, the gain constitutes proceeds from the sale of general personal property (as opposed to inventory) and is foreign-source income because she is a nonresident alien."
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In the end, the court sided with her.
"The short of it is that [the statute] does not of its own force render Rawat's inventory gain taxable because it does not change the fact that she sold a partnership interest, not inventory," Srinivasan wrote. "Once we reach that conclusion, the parties agree that the inventory gain from the sale is foreign-source income as to which Rawat owes no U.S. taxes."
