Partnerships are a form of business organization often used in business, whether to bring together small groups of joint venturers or larger groups such as investors in private equity funds. Partnerships are attractive as a form of business organization because of their general flow-through status for Canadian tax purposes. Partnerships are particularly attractive business organizations when tax-exempt participants, such as pension funds, are investors. However, a proposed tax change announced in the federal budget of last March is proving to be problematic for partnerships in which pension funds invest, particularly given the expansion of the original proposal that was made public in the form of draft amendments to the Income Tax Act (Canada) (the "ITA") released on August 14, 2012 (the “Draft Legislation”).
The proposal in question related to subsection 100(1) of the ITA. In general terms, subsection 100(1) is a targeted anti-avoidance rule aimed at transactions that effectively result in the avoidance of the recapture of depreciation by a taxable person. More specifically, as it has read since its introduction as part of the significant Canadian tax reform of 1972, this subsection can apply upon a disposition by a taxpayer of an interest in a partnership to a person exempt from tax under section 149 of the ITA (a "tax exempt"). In such a case, in general terms, the gain realized by the person on the disposition will be increased by an amount that reflects unrealized gains on partnership property other than non-depreciable capital property. The typical situation that can give rise to the application of subsection 100(1) is one in which a partnership holds a direct interest in depreciable real property. In such a situation, if a taxpayer realizes a capital gain on a disposition of an interest in the partnership to a tax exempt, unrealized recapture of depreciation on assets held in the partnership will be added to the capital gain realized by the taxpayer.
The announcement in the Budget focused on the proposed extension of the application of this subsection to certain dispositions of partnership interests to non-residents of Canada. More innocuous was the single sentence in the Budget papers that stated that the proposal will also “clarify” that section 100 applies “to dispositions made directly, or indirectly as part of a series of transactions, to a tax-exempt or non-resident person”. This caused some concern in Canadian investment fund circles, but many were hopeful that the proposals would prove to be practical and workable when the amending legislation was finally released. However, the opposite proved to be the case when the Draft Legislation was released. As proposed in the Draft Legislation, amended subsection 100(1) (in very general terms) could apply:
- on a direct transfer of a partnership interest by a taxpayer to a tax exempt;
- on a disposition of a partnership interest by a taxpayer if, as part of a series of transactions that includes the disposition, a tax exempt acquires an interest in the partnership;
- on a disposition of a partnership interest by a taxpayer to an acquirer that is itself a partnership if tax exempts hold more than 10% of the interests in the acquirer partnership, or to a trust if tax exempts hold more than 10% of the interests in the trust;
- on a “dilution, reduction or alteration” of an interest in a partnership of a taxpayer if, as part of the same series of transactions, there is an acquisition of, increase in or alteration in an interest in the partnership by or of a tax exempt and it can reasonably be concluded that one of the purposes of the series was to avoid the application of subsection 100(1).
It should be noted that one of the favourable changes to the original proposal included in the Draft Legislation is a “de minimis” exception to the rules. However, this rule is extremely limited in its application and does not go nearly far enough to be of practical advantage. In particular, the de minimis exception applies only on the purchaser side of the transaction (in other words, if the participation of tax exempts or non-residents in the purchasing partnership or trust is 10% or less). There is no de minimis exception for small holdings in a partnership, with the result that a disposition of even a small interest in a partnership can be subject to the new rules.
These new rules are proving to be of concern in structuring both closely held partnerships in which a tax exempt is a member and more widely held private equity funds in which tax exempts participate. Although it seems that tax exempts can participate in such partnerships from the establishment of the partnership without impacting the other members of the partnership, or upon subsequent issuances of partnership interests as part of a new equity raise, this is not the case for transfers of interests in partnerships. In particular, consideration has to be given to rights of first refusal and “shot-gun” rights which are typically built into closely held partnerships. Other examples of where new subsection 100(1) can be a concern include
- a fund offering with multiple closings, where investors coming in at a later closing do so by acquiring some of the pre-existing units held by investors that invested through an earlier closing (particularly if the later investors include tax-exempt entities);
- a multi-fund structure that requires rebalancing (again, this could involve subsequent closings where investors coming in later include tax-exempt entities – the point here is the risk that new subsection 100(1) might even impact the parallel fund in which the investing tax-exempt entities do not hold units); and
- forced sales of units by defaulting investors where units owned by the defaulting partners are acquired by non-defaulting partners that are tax exempt.
The government generally aims to have all of the legislation emanating from a federal budget enacted before the end of the calendar year of the budget. To this end, the usual practice for the Department of Finance is to release in early to mid-August draft legislation for comment, with a view to having a bill ready for introduction into the House of Commons upon its return from its summer recess, which will be September 17 this year. Accordingly, notwithstanding the significant issues still surrounding this legislation, it seems that it may well be introduced into the House within the next several weeks.