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Budget Announcement Affects Tax Exempts
In Canada, partnerships are attractive as a form of business because of their general flow-through status for tax purposes. This is particularly true for tax-exempt participants, such as pension funds, as 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 in the Income Tax Act (ITA). Taxand Canada investigates the impact on tax-exempt persons.
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 this subsection can apply upon a disposition by a taxpayer in a partnership to a person exempt from tax. In such a case, the gain realised by the person on the disposition will be increased by an amount that reflects unrealised gains on partnership property, other than non-depreciable capital property.
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 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 has caused some concern in Canadian investment fund circles.
These new rules are proving to be of concern for both close partnerships where one founding partner is tax exempt, and wider private equity funds, through which many persons who are tax exempt do business. Although it seems that tax exempts can participate in such both kinds of partnerships without impacting the other members, 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.