Canadian Income Tax Reorganizations – Contributing Property to a Partnership — Toronto Tax Lawyer Analysis
Introduction — Canadian Income Tax Reorganizations
Canadian law allows for businesses to take many different legal forms. The most common types of legal forms for Canadian businesses are sole proprietorships, corporations, partnerships, and trusts. Some Canadian businesses are structured using a combination of these forms. The choice of a legal form can have significant tax and non-tax consequences for the business and for investors. For example, corporations limit the liability their shareholders face from the incorporated business and some corporations are able to access the small business deduction. Partnerships on the other hand can flow out their losses to investors to offset their income from other sources. It is common for businesses to realize that their objectives would be better met by a legal form different than the form the business currently has. The Canadian Income Tax Act contains a complex group of provisions which can often allow businesses to change their legal form in a tax efficient manner.
Contributing Property to a Partnership – Canadian Income Tax Consequences
Many businesses, especially with third party investors, choose to operate as a partnership, a limited partnership, or through a structure which includes a partnership of as component. Unlike a corporation, a partnership is not considered by the Canadian Income Tax Act to be a taxpayer separate from its partners. Despite this, transferring property to a partnership is a taxable event which sometimes has adverse tax consequences. When a partnership acquires property from a taxpayer who is a member of the partnership immediately after the partnership acquired the property, then the partnership is deemed to acquire the property at fair market value as of the time of the transfer and the taxpayer is deemed to have disposed of the property and received proceeds of disposition equal to the fair market value of the property at the time of the transfer. So if the taxpayer's cost amount for the transferred property is less than the property's fair market value then the taxpayer will have realized a capital gain or earned business income depending on whether the property was capital property or inventory, and the resulting income will be taxed. Note that since the Canadian Income Tax Act only requires the taxpayer to be a member of the partnership immediately after the transfer to deem the taxpayer to have received fair market value proceeds of disposition, so if you buy into a partnership by contributing property with unrealized gains, you will realize those gains even if you were not previously a partner.
Contributing Property to a Partnership – 97(2) Rollover
In some circumstances a taxpayer can defer the gain realized by transferring property to a partnership. Subsection 97(2) of the Canadian Income Tax Act gives taxpayers access to a rollover similar to the one made available by section 85 (which allows taxpayers to defer the tax consequences of transferring property to a corporation in exchange for shares). In order to access this rollover, the taxpayer needs to meet a number of criteria. First, the taxpayer must receive consideration for the property that includes an interest in the partnership. Second, the property transferred must be capital property, Canadian resource property, foreign resource property or inventory of the taxpayer. Prior to the repeal of the eligible capital property regime, eligible capital property also qualified for the transfer. Third, the taxpayer must be a member of the partnership immediately after the transfer. Fourth, the partnership must be a Canadian partnership immediately after the transfer. A partnership is categorized as a Canadian partnership by the Canadian Income Tax Act at a particular time if at the particular time every member of the partnership is resident in Canada. Fifth, the taxpayer and all members of the partnership need to file a joint election on or before the earliest day when a taxpayer required to make the joint election is required to file an income tax return for the taxation year in which the transaction occurred.
If the taxpayer qualifies for and makes the election it must specify an elected amount. The taxpayer is deemed to have received proceeds of disposition (of the property transferred into the partnership) equal to the elected amount and the partnership is deemed to have acquired the property at a cost equal to the elected amount minus the value of any consideration provided to the taxpayer other than an interest in the partnership. If the elected amount chosen is equal to taxpayer's cost amount, then no gain is realized. If the elected amount chosen is between the taxpayer's cost amount and the fair market value of the property, then part of the gain is realized. The elected amounts that can be chosen by the taxpayer and the partnership are subject to several restrictions. First, the elected amount cannot exceed the fair market value of the property. Second, the elected amount cannot be below the lesser of the fair market value of the property and its cost amount to the taxpayer. This prevents the taxpayer from creating artificial losses by choosing a low elected amount. Third, the elected amount cannot be less than the value of the non-partnership interest consideration provided to the taxpayer. Despite this last restriction, the elected amount still cannot exceed the fair market value of the property.
Contributing Property to a Partnership - Tax Tips
The reorganization provisions of the Canadian Income Tax Act are complex and assistance from a Canadian tax lawyer is essential in planning and implementing reorganizations. While this article has summarized some of the tax considerations relevant to contributing property to a partnership, it does not cover all of the considerations that may be relevant to your reorganization. The precise details of these rules and of your particular situation can make a significant difference to the outcome. For example, the Canadian Partnership requirement for the 97(2) rollover means that the rollover is not available even if foreign partners own less than 1% of the partnership. This means that special tax planning is required when foreign partners are involved, no matter how small their overall ownership is. Another example of how the precise details of the organization rules matter is that subsection 97(2) allows taxpayers to roll their real estate inventory into a partnership while the corresponding provision for corporations, section 85, expressly disallows rolling real estate inventory into a corporation. This opens some types of tax planning opportunities to taxpayers in the business of buying and selling real estate or the business of real estate development.