Recently, in Rawat v. Commissioner, the D.C. Circuit reversed the Tax Court decision and held that a foreign partner would not be subject to U.S. tax on selling an interest in a partnership with “hot assets” subject to § 751(b). Although the issue at Rawat has been superseded by legislation (see § 864(c)(8)), the case has important lessons for statutory interpretation of the Tax Code:
Case Synopsis & Background
In Rawat, a non-resident alien individual recognized gain on the sale of a partnership interest in 2008. Almost all of which was categorized as capital gain under § 741 and, according to the Tax Court’s decision in Grecian Magnesite v. Commissioner, was not subject to U.S. taxation. However, a small portion of the appreciation in the partnership’s assets was attributable to inventory and treated as ordinary income under § 751. In such a situation, Section 751(a) provides that gain recognized by the partner would be treated as ordinary income based on the amount of income that would have been allocated to her if the partnership had sold all of its assets in a fully taxable transaction. The question in Rawat was whether Section 751(a) also operated to treat this amount as U.S. source ECI on the same basis.
The focus of the case was the interpretation of the phrase in § 751(a), providing that the hot asset amount is “considered as an amount realized from the sale or exchange of property other than a capital asset.”
The D.C. Circuit zeroed in on the statutory text, not only of § 751(a), but other highly relevant provisions. Most importantly, the D.C. Circuit looked to the definition of “ordinary income” in § 64. This foundational Code section is one that the author hadn’t read since law school. However, Section 64’s definitions appear to have had a crucial impact on the outcome of the case.
Section 64 provides that “ordinary income” includes “any gain from the sale or exchange of property which is [not] a capital asset...” The D.C. Circuit read this section as a definition of “ordinary income.” Accordingly, when Section 751(a) directs that the hot asset gain be treated as “an amount realized from the sale or exchange of property other than a capital asset,” this had the same meaning as providing that this gain was considered ordinary income, and nothing more. Treating the gain as ordinary income was very different from treating the sale of a partnership interest as a sale of the underlying inventory property.
After focusing on this close reading of the provision, the Court then buttressed its plain language reading of § 751(a) with legislative history. Section 751(a) was geared towards preventing partners from selling a partnership interest as a way to convert ordinary income to capital gains. This purpose from legislative history aligned closely with the statutory text.
In another key part of the D.C. Circuit’s opinion, it compared § 751(a) with § 751(b). Section 751(b), which involves distributions by partnerships that own hot assets, provides that the distribution “shall, under regulations prescribed by the Secretary, be considered as a sale or exchange of such property” (i.e., the hot assets themselves). This demonstrated that Congress knew how to expressly refer to a sale of the underlying property, rather than a term synonymous for ordinary income, when it wanted that result to obtain. See, also, e.g., § 897(g) (sale of partnership interest treated as sale of underlying U.S. real property assets); § 954(c)(4) (providing look-through rule for CFC’s sale of a partnership interest where the CFC owns 25%).
Takeaways from the D.C. Circuit opinion
Although the issue addressed in Rawat has been superseded by legislation, the D.C. Circuit’s opinion has important lessons for statutory interpretation. In light of Loper Bright’s directive that Courts must strive to find “the single, best meaning” of even an ambiguous statute, the tools of statutory construction employed by the D.C. Circuit in Rawat will become even more important.
Note that in interpreting § 751(a), the court looked holistically to other related Code sections. The text of a single tax code provision must be read in conjunction with other Code provisions, and not narrowly read in isolation.
The Tax Court engaged in the same statutory interpretation exercise as the D.C. Circuit, but with different results. The Tax Court started by looking at § 741 as treating sale of a partnership interest as a unified capital asset, and § 751(b) as providing an exception where the partnership interest was broken down into component parts. This approach looked more to broader concepts, rather than close reading of text. This illustrates that different courts can and will reach different results in finding the “plain meaning” of a statute.
As a parting thought, one interesting question remains: would the outcome have changed if the IRS and Treasury had issued regulations codifying the position in Rev. Rul. 91-32 prior to the litigation in Rawat (or Grecian Magnesite)? Under Loper Bright, the courts are required to resolve statutory ambiguity without giving Chevron deference to regulations. Would the single best meaning of § 751(a) have changed? We won’t definitively know the answer to that specific question because the issue was ultimately resolved through the legislative process.