When a partnership interest is sold by a taxpayer, the taxpayer may realize a capital gain to the extent the taxpayer’s proceeds of disposition for the partnership interest exceed the total of the adjusted cost base (the “ACB”) of the interest. In circumstances where the partnership interest is sold to a non-resident or tax-exempt person, however, consideration must be given to whether subsection 100(1) of the Income Tax Act (the “ITA”) could apply to the disposition, resulting in an increase to the taxpayer’s taxable capital gain. Also, in certain situations, subsection 100(2) of the ITA may apply to increase the taxpayer’s capital gain.
In the event either subsection 100(1) or (2) of the ITA apply, the taxpayer could be subject to an increased tax burden.
Subsections 100(1) and (1.1) of the ITA – Sale to certain persons
The analysis under subsection 100(1) of the ITA begins by identifying whether the taxpayer disposes of their interest directly or indirectly to one of the following persons as enumerated under subsection 100(1.1) of the ITA:
- a person exempt from tax under section 149 of the ITA;
- a non-resident person;
- another partnership if the interest can reasonably be considered to be held indirectly by a person that is exempt from tax, a non-resident person or a trust to the extent that the beneficiaries meet certain criteria; or
- a trust to the extent the beneficiaries meet certain criteria.
Subsection 100(1.1) of the ITA also provides look-through rules designed to ensure the application of subsection 100(1) of the 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) of the ITA.
If the partnership interest is acquired directly or indirectly by one of the persons mentioned above, then subsection 100(1) of the ITA could apply to increase the taxpayer’s taxable capital gain.[1] In such a case where one of the listed persons is acquiring the partnership interest, it is important to categorize 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 non-depreciable capital property versus increases in value attributable to the partnership’s other assets (referred to in this article as the “income assets”).
Should the purchaser of the partnership interest be a person, partnership or trust described by subsection 100(1.1) of the ITA, the partnership holds income assets, and no exceptions apply,[2] then the taxable capital gain realized by the partner disposing of its interest will be computed according to subsection 100(1) of the ITA. Consequently, the taxable capital gain from the disposition of the partnership interest will not simply be 50% of the capital gain. Instead, subsection 100(1) of the ITA will deem the disposing partner’s taxable capital gain to be the total of:
- 1/2 of the portion of the gain that may reasonably be attributable to increases in the value of the partnership property that is capital property (other than depreciable property); and
- the whole of the remaining portion of the capital gain.
Therefore, should subsection 100(1) of the ITA be applicable, the disposition of the partnership interest will not benefit from complete capital gains treatment and the portion of the gain attributable to income assets will be fully included in their income.
Let’s take for example a vendor who holds a partnership interest as capital property with the following tax attributes: fair market value of $100,000 and ACB of $50,000. If the vendor sells its interest to a Canadian resident individual, the vendor will realize a $50,000 capital gain and a $25,000 taxable capital gain.
However, if the sale is made to a non-resident individual, and the underlying assets held by the partnership are solely income assets, there may be an increased tax burden for the vendor. Because no portion of the taxpayer’s capital gain can be attributable to increases in the value of non-depreciable capital property of the partnership, unless an exception applies, the vendor’s taxable capital gain would be deemed to be the whole of the capital gain, which would be $50,000.
Please note that there are certain exceptions to the application of subsection 100(1) of the ITA;[3] however, we will not address them in the context of this overview.
Subsection 100(2) – The effect of a negative ACB
In addition to the potential increase in the taxpayer’s taxable capital gain under subsection 100(1) of the ITA, subsection 100(2) of the ITA can also increase the taxpayer’s capital gain on the disposition of a partnership interest.
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 either increase[4] or reduce the ACB.[5] For example, contributions of capital to the partnership[6] or allocations of the profits of a partnership to the partners[7] will increase the ACB, whereas, partnership losses[8] and distributions[9] 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) of the ITA, if a partnership interest is sold with a negative ACB, the capital gain of the vendor will be increased by the amount of the negative ACB. Subsection 100(2) applies to a sale of partnership interest to any person (not only those persons listed in subsection (1.1)). Consequently, the taxpayer will be subject to a greater tax burden following the sale.
Conclusion
To conclude, the goal of subsection 100(1) of the ITA is to prevent a taxpayer from receiving full capital gains treatment on the sale of a partnership interest when a sale of the underlying assets of the partnership would be fully taxable as ordinary income. Absent this rule, a partnership interest could be transferred to a tax-exempt person and accrued gains could be triggered without incurring any Canadian tax. As such, depending on the identity of the purchaser and the type of underlying assets held by the partnership, a taxpayer may be subject to a greater tax liability on the sale of a partnership interest than the taxpayer initially anticipated. Also, in the event of a negative ACB at the time of sale, importance should be given to subsection 100(2) of the ITA as the capital gain could be increased.
A case-specific analysis is required to determine whether subsections 100(1) or (2) of the ITA are applicable to a sale of a partnership interest. Additionally, there may be other parts of section 100 of the 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.
[1] Notwithstanding the normal computation of the taxable capital gain pursuant to paragraph 38(a) ITA.
[2] Subsections 100(1.1)(1.2) to (1.5) ITA.
[3] Subsections 100(1.1)(1.2) to (1.5) ITA.
[4] Paragraph 53(1)(e) ITA.
[5] Paragraph 53(2)(c) ITA.
[6] Paragraph 53(1)(e)(iv) ITA.
[7] Paragraph 53(1)(e)(i) ITA.
[8] Paragraph 53(2)(c)(i) ITA.
[9] Paragraph 53(2)(c)(v) ITA.
