The 2011 federal budget has proposed to limit the tax deferral that corporations have benefited from on partnership income received as corporate partners. Under current income tax rules, income earned by a corporation as a member of a partnership is included in the corporation’s income for the corporate tax year in which the fiscal period of the partnership ends. If a corporation carries on a business through a partnership that has a fiscal period that ends after the end of the corporation’s taxation year, taxation of the partnership earnings can be deferred by up to one year. For example, if a corporation with a December 31, 2010 year-end is a partner of a partnership with a fiscal period ending January 31, 2011, the corporation can defer the taxation of 11 months of income (i.e. income from February 2010 to December 2010) to the corporation’s 2011 taxation year. Since the partnership’s fiscal year ends in 2011, its income would be reported in the corporation’s year ended December 31, 2011. Larger deferrals become possible if a multiple-tier partnership structure is used (i.e. where the partnership is a member of another partnership).
The government has found the deferral to be inequitable and proposed to limit it by requiring certain corporate partners to accrue partnership income for the portion of the partnership’s fiscal period that falls within the corporation’s taxation year (the “stub period”). Note that in 1995, the government closed the possibility of such a deferral for individuals carrying on business through a partnership or sole proprietorship. It’s worth noting that it is estimated that the federal government would receive an additional $2.85 billion of tax revenue from this proposed change over the first four years that additional tax revenue will arise.
Although parliament was dissolved before this budget measure was adopted, it is expected to be re-introduced by the new government due to its nature, as it is aimed at closing a “tax loophole” and the estimated tax revenue at stake. As set out in the budget papers, this measure is to apply to taxation years of a corporation that end after March 22, 2011. At this time, it is not known with certainty that this will be the effective date, but corporate partners should consider that the new government may implement the measures based on this date.
Which corporations are impacted by the proposals?
The proposals will apply to a corporate partner (other than a professional corporation, as they were impacted by the 1995 changes) for a taxation year, where:
- The corporate partner is a member of a partnership at the end of the taxation year,
- The partnership’s last fiscal period that began in the taxation year ends in a subsequent taxation year of the corporate partner (i.e. the partnership and the corporate partner have different year-ends), and
- The corporate partner has a significant interest in the partnership. This means that the corporate partner, together with affiliated and related parties, was entitled to more than 10% of the partnership’s income (or assets in the case of a wind-up) at the end of the last fiscal period of the partnership that ended in the taxation year.
These rules will apply to any corporate partner that meets the conditions noted, even if other members of the partnership include individuals or professional corporations.
What types of partnership income are caught by the proposals?
The 1995 changes focused exclusively on business income. However, it appears that the changes introduced in the 2011 budget will have broader application. In one part of the budget papers, it is stated that the deferral will be ended for a partner’s share of stub period income from the partnership, other than their share of dividends received from other corporations. This will mean that the 2011 proposals will likely be a lot more complicated to apply in practice when compared with the 1995 changes, as private corporations pay different tax rates on small business income, general business income and investment income. It is unclear whether the government has considered this, as the 1995 rules applied to only one kind of income.
How will the deferral be limited?
A partnership will still be allowed to have a fiscal period that differs from the taxation year ends of its corporate partners; however, corporate partners will be required to accrue income from the partnership for the stub period. A stub period accrual will be determined based on a formula, which prorates the amount of income from the partnership for the fiscal period ending in the corporation’s taxation period based on the number of days in the stub period to the number of days in the partnership’s fiscal period that ends in the taxation year. Alternatively, the corporate partner can designate an amount lower than the income that is determined using the formula. However, if the designated amount ends up being less than the actual stub period income (verified once the partnership’s fiscal year has ended) and the income determined using the formula approach, the corporate partner will be subject to an additional income inclusion in the following year. This income inclusion will be equal to the amount of the shortfall multiplied by the average prescribed interest rate that applies for tax underpayments. Where the shortfall is larger than 25%, there will be a further income inclusion. Therefore, it may be prudent to use the formula approach, unless the actual stub period income will be lower and the amount is known with some certainty. Unfortunately, using the formula approach initially, and adjusting later for actual prorated stub period income is not currently an option.
Provision has been made for corporate partners to reduce the amount of the stub period accrual by their share of designated resource expenses incurred by the partnership in the stub period. Designated resource expenses include Canadian exploration expense, Canadian development expense, Canadian oil and gas property expense and foreign resource expense. In order to take advantage of this reduction, corporate partners will be required to obtain information in writing evidencing the nature and amount of each expense and the corporate partner’s share of that expense from the partnership before filing their corporate tax return. A potential issue to consider will be whether this information can be received in the required time period from the partnership.
As these proposed measures could result in significant additional incremental partnership income for the first corporate taxation year ending after March 22, 2011 (as set out in the budget), transitional relief (where certain conditions are met) has been allowed by way of a transitional reserve. For the corporation’s first year-end under these rules, a 100% reserve will be allowed. The incremental amount to be taxed will then be gradually taxed over the five taxation years that follow. As a preliminary observation, it would appear that the transitional relief will end if the partner sells their partnership interest or the partnership is wound-up during the transitional period. Therefore, these rules will need to be considered carefully before a partnership interest is sold.
Fiscal period changes
With the new requirement to accrue stub period income, some partnerships may wish to change their fiscal periods. The budget proposals include a one-time election for partnerships where all members are corporations, and where certain other conditions are met, that will enable a partnership to change its fiscal period. To meet certain conditions and to determine an appropriate new fiscal period, the partnership will need to gather information on the taxation year-ends and filing deadlines of all of its corporate partners. This requirement needs to be taken into consideration when determining whether to make the election.
Note that the proposals do not include any special rules that would allow a corporate partner to change its year-end to harmonize with a partnership. However, we assume the Canada Revenue Agency would agree to such a change if an application is made in required form.
Fiscal year-ends for multiple-tier partnership structures
Under the proposals, all of the partnerships that are part of a multiple-tier partnership structure will be required to have the same fiscal period, but it is not necessary for this fiscal period to align with the taxation year of any of the corporate partners. This requirement is being introduced because the stub period accrual rules described are not adaptable to address the tax deferral that arises in multiple-tier structures which may have both corporations and partnerships as members at various levels in the structure. In general, multiple-tier partnerships that are not required to have a December 31 fiscal period under existing rules will be allowed a one-time election under certain conditions which will enable them to choose a common fiscal period. If no such election is filed, the common fiscal period of the partnerships in a multiple-tier partnership structure will end on December 31, 2011 (and on December 31 for subsequent fiscal periods). With a common year-end for these partnerships, the stub period rules and transitional relief discussed above will apply.
Depending on the number of partnerships in a multiple-tier structure, the requirement to change the fiscal periods of the partnerships could prove to be quite onerous with the co-ordination and compliance involved. And, the income deferred may have also been larger.
Summary
These proposals provide a significant change for corporate partners, as well as for partnerships that are required to change their fiscal period and for those that choose to do so. Although the proposals need to be reintroduced by the new government and more details will be announced, partnerships and corporate partners need to consider their impact. As discussed, there will be decisions to be made at both the partner and partnership level. We will provide further updates as more information becomes available.
If you have questions concerning these changes, please contact your BDO advisor.
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