Legal Forms for Canadian Businesses – Canadian Partnership Status
The Canadian legal environment provides businesses with a number of different choices for legal forms to structure themselves, most prominently corporations, sole proprietorships, partnerships and limited partnerships. These forms have different legal and tax aspects associated with them. Partnerships are a useful business form with distinct tax advantages, but also some unexpected tax traps for unwary taxpayers. This article briefly reviews different business forms and then summarizes the tax aspects of partnerships in the Canadian legal landscape and describes how partnerships with Canadian Partnership status are treated differently by Canadian Income Tax law.
If an individual begins carrying on a business by himself or herself without setting up a different legal form for the business, then the individual will be operating a sole proprietorship. In this legal form, there is no concept of a business entity separate from the individual. The individual will be fully liable for all liabilities incurred in the course of carrying on business. The individual will need to report the gross income and profits or loss of the business as personal business income on the T1 personal income tax return and is also able to claim the losses of the business against other sources of income.
Corporations are the most familiar business form for most Canadians. Corporations are treated as a separate legal person from their shareholders (i.e. the persons who own a corporation). One consequence of this is that except in special circumstances creditors of a corporation can only access the assets of the corporation and not the assets of its shareholders. From a Canadian income tax perspective, corporations are treated as independent taxpayers responsible for paying tax on their own income separate from their shareholders.
A partnership is a relationship which exists between two or more persons carrying on a business together with a view to profit. It is created under the common law by partners operating a business together. The partners are personally liable for the debts of the partnership. Canadian income tax law does not treat partnerships as taxpayers liable to pay tax on the income generated by the business of the partnership. Instead, every partnership has a fiscal period (usually one year in length ending on December 31). The income or loss earned by the partnership during that fiscal period is allocated to its partners as laid out in the partnership agreement. Each partner then includes their portion of the income or loss from the partnership on their personal tax return for the year in which the partnership's fiscal period ends. This loss flow through income tax treatment of partnerships can be very useful for businesses which are expected to operate at a loss for an extended period of time before becoming profitable as this allows the partners to shelter their income from other sources using the partnership's losses. A written partnership agreement prepared by an expert Canadian tax lawyer is extremely advisable but not mandatory.
A limited partnership is a type of partnership created by a Limited Partnerships Act in the jurisdiction of creation and that includes at least one general partner and at least one limited partner. A general partner is any partner who is not a limited partner. General partners operate as described in the preceding section. A limited partner is not permitted to take an active role in running the partnership's business but is also not liable to creditors of the partnership other than for the limited partner's investment into the limited partnership. This business form is useful when the partnership tax treatment is desirable and some investors in the business will provide funding but not be involved in operating the business. A written Limited Partnership agreement is required.
What is a "Canadian Partnership" – Canadian Partnership Status
The Canadian Income Tax Act defines a "Canadian Partnership" as a partnership in which every member is a tax resident of Canada at the relevant time. Note that this definition is independent of the whether a partnership is a limited partnership or not. Similarly, the definition is independent of the jurisdiction under which the partnership is formed. A partnership formed under Ontario law is not a Canadian Partnership if it has a non-resident member. In theory, a partnership formed under the law of a foreign jurisdiction all of whose members are Canadian residents would be a Canadian Partnership.
Importantly, what matters for this classification is whether there is a single non-resident member of the partnership. This means that even if 99% of a partnership is owned by Canadian resident partners, the partnership will still fail to meet the test of a Canadian partnership, which can result in significant adverse tax consequences.
Tax Deferred Contributions of Property to a Partnership – Canadian Partnership Status
By default, most contributions of property by a partner to the partnership are a taxable event. 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.
In some instances, it is possible to contribute property to a partnership on a tax deferred basis when the taxpayer making the contribution is a member of the partnership immediately following the contribution. One of the requirements for making a tax deferred contribution is that the partnership will be Canadian Partnership status immediately following the contribution. As such, maintaining Canadian Partnership status is important if further contributions are to be made to a partnership on a tax deferred basis.
Tax Efficient Dissolution of a Partnership – Canadian Partnership Status
By default, when a partnership distributes property to a person who was a partner immediately prior to the distribution, the partnership is deemed to have sold that property at its fair market value and the recipient is deemed to have purchased that property at fair market value. This poses a potential problem if the partners ever want to dissolve the partnership or change the legal structure of the business as removing property from the partnership will trigger the taxation of unrealized gains on partnership property.
Several of the tools available for effecting a tax deferred dissolution of a partnership are only available to Canadian Partnerships. The Canadian Income Tax Act allows all the members of a Canadian Partnership to jointly elect to convert the Canadian Partnership into co-ownership of the partnership property without realizing gains on the partnership property. A similar provision can allow a Canadian Partnership to be converted into a sole proprietorship without the sole proprietor realizing gains when exactly one of the partners carries on the business of the Canadian Partnership. The Income Tax Act also allows for the tax deferred transfer of property from a predecessor partnership to a successor partnership when the predecessor partnership ceased to exist by virtue of the death or insolvency of a partner with the remaining partners continuing on the original partnership business. This treatment is only available when both the predecessor partnership and the successor partnership are Canadian Partnerships.
It is also possible for partnerships to transfer partnership property to a Canadian corporation on a tax deferred basis if the consideration for the partnership property includes shares of the corporation. Notably, the partnership in this transaction need not be a Canadian Partnership. The definition of "Canadian corporation" includes corporations that are both resident and incorporated in Canada. As such, it is possible that a non-Canadian Partnership can use this method to transfer property out of the partnership on a tax deferred basis.
Non-resident Withholding Tax on Payments to a Partnership –Canadian Partnership Status
Canada levies a non-resident withholding tax that applies to certain types of payments made by Canadian tax resident persons to non-resident persons. Some of the main types of payments to which the tax applies are dividends, interest, and rent for Canadian real estate. By default, the tax is 25% of the gross amount of the payment. The payor is jointly liable with the non-resident for the tax and is required to withhold the tax from each payment and then remit the tax to the CRA. In some circumstances, non-residents operating in Canada may also be required to withhold and remit non-resident withholding tax on payments they make to other non-residents.
For the purpose of the non-resident witholding tax, all non-Canadian Partnerships are treated as non-resident persons for the purpose of the non-resident witholding tax. This means that the tax applies on payments made to a non-Canadian Partnership.
Canada is a party to many bilateral tax treaties which reduce the rate of the non-resident witholding tax on payments made to tax residents of specific other countries. If some of the non-resident members of a partnership are eligible for a reduction in the rate of witholding based on their countries of tax residence, the partnership can have it's payer reduce witholding to an appropriate blended rate. The Canada Revenue Agency's form NR302 is used by non-Canadian Partnership's to declare their eligibility for a reduced witholding tax rate to payor's. The form suggests that Canadian resident members of a non-Canadian Partnership contribute to the blended rate as if their witholding rate was 0%. It is unclear that this is correct under the law and it is seemingly inconsistent with CRA's prior administrative positions so there can be some uncertainty in determining the correct rate. In the event that a Canadian member ends up paying witholding tax, they will be able to obtain credit against the member's ordinary income tax.
Pro Tax Tips – Canadian Partnership Status
Canadian Partnerships have a different set of tools and tax obligations compared to non-Canadian Partnerships. As such, it is very important to correctly classify any existing partnerships that are part of an existing or anticipated structure. It is also necessary to be aware that since tax residence is in large part a factual question, personal or business changes made by a single partner can unexpectedly cause a partnership to lose Canadian Partnership status. It is crucial to get advice from an experienced Toronto tax lawyer to avoid unexpected tax issues in setting up a structure, planning a transaction, engaging in a reorganization, or implementing a tax residence relevant operational change.