This edition of Tax Notes will provide an overview on a few tax considerations regarding the sale of a partnership interest. The sale of a partnership interest can trigger capital gains depending on whether the proceeds of disposition exceed the total of the adjusted cost base (the “ACB”) of the interest. As such, the proper determination of the ACB is important.
Moreover, it is interesting to note that whether the taxpayer transferred capital property or income assets to the partnership, the sale of the taxpayer’s interest will, generally, be considered of capital nature and therefore the taxpayer could benefit from the capital gains treatment. However, the taxpayer should consider the effects of subsection 100(1) of the Income Tax Act (the “ITA”) prior to concluding a sale. More specifically, depending on both the identity of the purchaser and the nature of the underlying assets held by the partnership, there may be unfavorable tax consequences for the taxpayer in computing their taxable capital gain. Also, in certain situations, subsection 100(2) ITA may also apply to increase the taxpayer’s capital gain.
In the event either subsection 100(1) or (2) ITA apply, the taxpayer could be subject to an increased tax burden.
Subsections 100(1) and (1.1) ITA – Sale to certain persons
The analysis under subsection 100(1) ITA begins by identifying whether the taxpayer disposes of his interest directly or indirectly to one of the following persons as enumerated under subsection 100(1.1) ITA:
- a person exempt from tax;[1]
- a non-resident person;[2]
- another partnership if the interest can reasonably be considered to be held indirectly by a person that is exempt from tax, a non-resident or a trust to the extent that the beneficiaries meet certain criteria;[3] or
- a trust to the extent the beneficiaries meet certain criteria.[4]
As can be seen, subsection 100(1.1) ITA provides look-through rules designed to ensure the application of subsection 100(1) ITA even where the sale of a partnership interest is made to another partnership or a trust for which a partner or beneficiary may be captured by subsection 100(1.1) ITA.
If the sale is made directly or indirectly to one of the persons mentioned above, then subsection 100(1) ITA could apply to increase the taxpayer’s taxable capital gain.[5] In such case, it is important to qualify the underlying assets held by the partnership to determine which portion of the taxpayer’s capital gain is attributable to increases in value relating to capital property versus income assets.
Should the purchaser be captured by subsection 100(1.1) ITA and the partnership holds income assets and no exceptions apply[6], then the taxable capital gain will be computed according to subsection 100(1) ITA. Consequently, the taxable capital gain will not simply be 50% of the increase in value of all the partnership property. Instead, subsection 100(1) ITA will deem the taxable capital gain to be the total of:
- 50% of the gain attributable to the increase in value of capital property; and
- the remaining portion of the gain attributable to the increase in value of income assets.
Therefore, should subsection 100(1) ITA find application, the disposition of the partnership interest will not benefit from complete capital gains treatment.
Let’s take for example a person who holds a partnership interest with the following tax attributes: fair market value of $100,000 and ACB of $50,000. If this person sells its interest to another partnership owned entirely by Canadian residents, regardless of the whether the underlying property held by the partnership comprises only of income assets or capital assets, the $50,000 increase in value will be considered as a capital gain resulting in a total taxable capital gain of $25,000.
However, if the sale is made to a purchaser that is a partnership owned partially by 50% Canadian residents and 50% non-residents and the underlying assets held by the partnership for which the interest is sold comprises only of income assets there can be an increased tax burden for the taxpayer. In this context, the taxable capital gain will be calculated according to the respective interest held in the purchaser by the Canadian residents and non-residents. Accordingly, 50% of the $50,000 gain, being $25,000, will be capital gain and result in a first portion of taxable capital gain in the amount of $12,500. As for the second portion of the taxable capital gain, this amount will correspond to the remaining portion of the $50,000 gain, being $25,000. As a result, this sale will generate a total amount of $32,500 in taxable capital gain instead of $25,000.
Please note that there are certain exceptions to the application of subsection 100(1) ITA;[7] however, we will not address them in the context of this overview. Other than subsection 100(1) ITA, subsection 100(2) ITA can also increase the taxpayer’s gain.
Subsection 100(2) – The effect of a negative ACB
As initially mentioned, the proper determination of the ACB is important in computing the taxpayer’s capital gain. The ACB of a partnership interest is calculated according to different variables that can increase,[8] but also reduce the ACB.[9] For example, contributions of capital to the partnership[10] or share of profits[11] will increase the ACB, whereas, partnership losses[12] and distributions[13] will reduce the ACB.
There will not necessarily be immediate tax consequences in the event the ACB of the partner’s interest falls below zero. However, pursuant to subsection 100(2) ITA, if the interest is sold with a negative ACB, the capital gain will be increased by the amount of the negative ACB. Consequently, the taxpayer will be subject to a greater tax burden following the sale.
To conclude, the goal of subsection 100(1) ITA is to prevent income assets from receiving the capital gains treatment. As such, depending on the identity of the purchaser and the type of underlying assets held by the partnership the taxpayer may be subject to a greater tax liability. Also, in the event of a negative ACB, importance should be given to subsection 100(2) ITA as the capital gain could be increased.
A case-specific analysis is required to determine whether subsections 100(1) or (2) ITA are applicable to a sale of a partnership interest. Additionally, there may be other parts of section 100 ITA not discussed herein that may apply to your situation.
Contact a member of the Miller Thomson LLP Corporate Tax team if you have any questions or concerns regarding partnership taxation.
This article was co-authored by Alexandre Chano, former Associate with Miller Thomson.
[1] Paragraph 100(1.1)(a) and section 149 ITA.
[2] Paragraph 100(1.1)(b) ITA.
[3] Paragraph 100(1.1)(c) ITA.
[4] Paragraph 100(1.1)(d) ITA.
[5] Notwithstanding the normal computation of the taxable capital gain pursuant to paragraph 38(a) ITA.
[6] Subsections 100(1.1)(1.2) to (1.5) ITA.
[7] Subsections 100(1.1)(1.2) to (1.5) ITA.
[8] Paragraph 53(1)(e) ITA.
[9] Paragraph 53(2)(c) ITA.
[10] Paragraph 53(1)(e)(iv) ITA.
[11] Paragraph 53(1)(e)(i) ITA.
[12] Paragraph 53(2)(c)(i) ITA.
[13] Paragraph 53(2)(c)(v) ITA.
