Many types of businesses (including the ownership of real estate) are structured as partnership. The partners can be individuals, corporations or even other partnerships.
If the interest in the partnership is sold, then normally a capital gain or loss will result from the disposition of the partnership. It is well established that an interest in a partnership is a separate asset for Canadian income tax purposes that is distinct from the underlying assets of the partnership. Furthermore, this interest should be viewed as capital property, even if the underlying assets are mainly inventory.
When it comes time to sell an interest in the partnership, it should not matter, in terms of the tax implications, who buys it, right? The only thing that should matter is the “adjusted cost base” of the interest, and the sale price, right?
Unfortunately, in certain cases, the question of who buys the partnership does matter quite a bit in terms of the tax implications, particularly after little-known amendments to a little-known section were made to the Income Tax Act (‘the Act”) in 2012.
Before those amendments, this issue generally only arose of an interest in the partnership was sold to a tax-exempt entity, such as a Registered Pension Plan.
In particular, subsection 100(1) can now result in 100% taxation, as opposed to the normal 50% taxation, of capital gains from the disposition of partnership interests, if the purchaser is a nonresident. Furthermore, this treatment can also apply if the purchaser is another partnership that has nonresident members, unless the percentage owned by nonresidents is below a 10% de minimis threshold.
In essence, the rationale behind subsection 100(1) is to try to curtail situations where Canadians realize 50% taxable capital gains in situations where the potential for taxation, of underlying recapture of capital cost allowance (“CCA”) or inventory gains, will be shifted to persons who will not ultimately pay Canadian tax.
Because of this fact, there is an exception to the application of this provision (in subsection 100(1.3) of the Act) where the partnership interest is sold to a non-resident person and the partnership carries on business through a permanent establishment in Canada, and at least 90% of its properties (on a fair market value basis) are used in that business. The assumption here is that, in those cases, the recapture or inventory gain will still potentially be subject to Canadian tax.
However, what if a Canadian owns an interest in a partnership that is carrying on business outside of Canada; or that this used to hold real estate outside of Canada; or even in Canada, if the real estate activities are not considered a business? In those cases, this provision can apply.
Unfortunately, even a little thought regarding the mechanics of the gain inclusion under subsection 100(1) will lead one to the conclusion that its effects are overreaching in that even underlying gains that would otherwise be only 50% taxable will be subject to 100% taxation.
This is because of the fact that the only portion of the capital gains from the disposition of the partnership interest, for which 50% taxation is preserved, is the portion of gains that pertains to non-depreciable capital property-everything else becomes 100% taxable.
This would be true even though such gains might pertain to:
- Capital gains on depreciable property-that is, value that exceeds the original cost on which CCA has been claimed. This would be particularly applicable to partnerships that own buildings, or IP such as patents that would be depreciable property
- Eligible capital property, such as “goodwill”.
Clearly, in such cases, the tax burden resulting, from a sale of a partnership interest to a nonresident, can result in a greater burden of taxation for the vendor, than that which would have resulted if the partnership had sold its assets. In addition, “to add insult to injury”, the price paid for the acquirer of the interest will sometimes be discounted to reflect the fact that there is no way to “bump” the tax value (for Canadian tax purposes) of the underlying partnership assets for the purchaser.
Unfortunately, very few Canadian tax advisors are attuned to the dangers of this provision.
 See particularly the decision of the Exchequer Court of Canada in MNR v. Nathan Strauss, 60 DTC 1060
 Canadian tax law has no provision analogous to section 754 of the Internal Revenue Code under which the tax basis of partnership assets may be increased when an interest is sold. Of course, this will only be of significance in those situations where there would be a continuing liability for taxation in Canada, such as in the case where the partnership owns real estate in Canada.