Denial of section 88 "bump" on partnership interests
Section 88 of the Income Tax Act (Canada) (the "Tax Act") applies on an acquisition of control of one taxable Canadian corporation (the "Subsidiary") by another taxable Canadian corporation (the "Parent") to permit the Parent to increase (or "bump") the tax cost of certain assets owned by the Subsidiary at the time of the acquisition of control upon a subsequent winding-up of the Subsidiary into, or a vertical amalgamation of the Subsidiary with, the Parent. In simplified terms and subject to certain limitations, the "bump" permits the Parent to translate its acquisition cost of the shares of the Subsidiary into tax cost of assets acquired from the Subsidiary on the subsequent winding-up or amalgamation of the Subsidiary.
The "bump" is available only in respect of certain types of capital assets, including land, shares and partnership interests. Ineligible assets include eligible capital property, depreciable property, inventory and resource property. (Budget 2012 describes these types of property as "income assets" on the basis that a sale of these types of property could result in the recognition of income amounts.)
The Government has identified, as a tax avoidance concern, the use of corporate partnerships to circumvent the rules that deny a "bump" in respect of a Subsidiary's income assets. Where a Subsidiary's income assets are indirectly held through a partnership, the cost of the partnership interest can be bumped on a winding-up or amalgamation following the acquisition of control of the Subsidiary. Subsequent to the wind-up or amalgamation, the Parent may have tax cost in the partnership interest that permits it to transfer the partnership interest to an affiliate or a third party without incurring a tax liability. In addition, because of the flow-through nature of partnerships, the purchaser that indirectly acquires the income assets through the partnership may be able to shelter any imbedded gain in these assets or may not be subject to tax on these gains.
Budget 2012 proposes to amend the rules in section 88 of the Tax Act to deny the "bump" on partnership interests to the extent the accrued gain in the partnership interests is "reasonably attributable to" the amount by which the fair market value of the income assets held by the partnership at the time of the relevant acquisition of control exceeds their cost amount.
The Notice of Ways and Means Motion that accompanied Budget 2012 provides more detail about how the amount that is reasonably attributable to "income assets" is to be determined. Two important features of this calculation are that it looks through to assets held indirectly through one or more partnerships and that it requires the fair market value of income assets to be determined without reference to any liabilities that may relate to the income assets. One of the limitations on the amount of the available increase or "bump" in the tax cost of property is that it cannot exceed the amount by which the fair market value of the property at the time of the acquisition of control exceeds its tax cost. Any determination of fair market value of a partnership interest itself would take account of the partnership's liabilities. Accordingly, the latter rule effectively allocates all of a partnership's liabilities to its capital property even though, as a factual matter, this may not be the case.
This proposed change applies to windings-up that begin on or after Budget Day (i.e., March 29, 2012) and amalgamations that occur on or after Budget Day. There is an exception for windings-up that begin before 2013, and amalgamations that occur before 2013, if
- the Parent acquired control of the Subsidiary before Budget Day or was obligated to acquire control of the Subsidiary "as evidenced in writing" before Budget Day; and
- there is written evidence that the Parent intended to amalgamate with, or wind-up, the Subsidiary.
This exception will not apply where the Parent's written arrangements entered into before Budget Day permit the Parent to be excused from the obligation to acquire control of the Subsidiary if there is an amendment made to the Tax Act.
Sale of partnership interest to a non-resident
Subsection 100(1) of the Tax Act currently provides that, on a sale of an interest in a partnership to a tax-exempt person, what would otherwise be the selling taxpayer's capital gain will be fully taxable to the extent it is attributable to anything other than increases in the value of the partnership's non-depreciable capital property. This rule is intended to ensure that gains on a partnership's income assets are fully taxable on a sale to a tax-exempt entity because the tax-exempt entity will not subsequently be subject to tax on these gains.
Budget 2012 proposes to extend this rule to sales of partnership interests to non-residents, unless immediately before and immediately after the acquisition, the partnership uses all of its property in carrying on its business through a Canadian permanent establishment. This change is intended to prevent indirect transfers of income assets to non-residents of Canada in a manner that taxes the Canadian seller on a capital gains basis and allows the non-resident to access exemptions from tax under domestic law or a bilateral tax treaty to avoid Canadian tax on any gain on income assets. (Where the partnership carries on business through a Canadian permanent establishment, gains on the income assets will continue to be subject to Canadian income tax.)
Budget 2012 also proposes to amend section 100 of the Tax Act to "clarify" that it applies to dispositions made "directly, or indirectly as part of a series of transactions" to a tax-exempt person or to a non-resident.
This proposed change applies to all dispositions of partnership interests made on or after Budget Day. There is a proposed exception for arm's length dispositions that occur before 2013 that a taxpayer is obligated to make pursuant to a written agreement entered into by the taxpayer before Budget Day, unless the agreement provides that the taxpayer can be excused from the obligation if amendments are made to the Tax Act.
The foregoing provides only an overview. Readers are cautioned against making any decisions based on this material alone. Rather, a qualified lawyer should be consulted.
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