Tax Traps & Tips: New Partnership Rules: Not Quite
By Deepk K. Jaswal, CA
Budget 2011 introduced new rules designed to limit the deferral of income through the use of a partnership structure. Under these proposed rules (or Bill C-13), corporations will no longer be allowed to use a partnership with a misaligned year-end as a mechanism to defer income for a taxation year; nor will corporate taxpayers be able to use multi-tiered partnerships to defer income for multiple taxation years.
These rules are intended to place corporate taxpayers on the same footing as individuals. However, while partnership deferral opportunities were eliminated for most individuals in 1995; the 2011 rules will not put a full moratorium on the use of partnerships in a corporate structure.
The proposed rules will require a corporation to accrue income from a partnership for the portion of the partnership's fiscal period that falls within the corporation's taxation year. Transitional relief may be available for any additional income for the first year the new rules apply, which could be brought into income over a five-year (or possibly six-year) period.
The details of Bill C-13 can be complex and very technical; therefore, this article is intended to provide a brief overview of the proposed rules and of the options that will be available for single-tiered partnership structures.
Who is affected?
The proposed rules will apply to taxation years ending after March 22, 2011. They will only apply to a corporation (other than a professional corporation) that holds a significant interest in a partnership—one with a fiscal period different from that of the corporate partner. A significant interest is referred to as a corporation (alone or with a related/affiliated group) that holds an interest in a partnership and is entitled to more than 10% of the partnership's income or loss, or the assets/net liabilities of the partnership if it ceased to exist.
Decisions to be made
When reviewing the new rules for each partnership, corporate partners will find themselves at a fork in the road, facing two options: They could either accrue an estimate of their share of the partnership income (known as the "adjusted stub period accrual") or they could make a one-time election to align the partnership's fiscal year-end with the corporate partner.
Both options will be available on a partnership-by-partnership basis. Careful consideration should be taken when contemplating either one.
Adjusted stub period accrual (ASPA)
The ASPA alternative is the default scenario wherein a partnership will continue to have a fiscal period that differs from that of its corporate partner.
Under the ASPA alternative, a corporate partner will accrue an estimate of the partnership's income, which otherwise would have been deferred due to a misaligned year-end. The ASPA would be the corporation's share of income for the fiscal period ending in the corporate partner's taxation year, pro-rated for the number of days in the stub period. The corporate partner could designate a discretionary amount to reduce the ASPA to reflect its knowledge of the actual partnership income for the stub period; however, once this designation is made, it could not be revoked.
There is also a risk associated with making the discretionary designation. If a corporate partner under-reports its ASPA through the discretionary deduction, it will be required to include an income shortfall adjustment in its income.
Alternatively, the members of a partnership may elect to align the partnership's fiscal period with the corporate partner's fiscal period. Under a single-tiered partnership structure, this election will be available on a one-time basis and will have to be filed by the filing due date of the corporate partner's tax return for the first taxation year ending after March 22, 2011. The filing would include any deemed year-end the corporate partner may have after March 22, 2011.
Once the alignment has been made, the corporate partner would include its allocation of earnings from the partnership in computing its taxable income for the period. In the first year of alignment, this could result in the corporate partner including an additional year of earnings from the partnership. Transitional relief may be available for this; however, if the partnership is allocating losses to the corporate partner, the corporate partner may be able to accelerate the allocation of losses from a partnership through an alignment election.
The government has indicated that the proposals under the ASPA alternative will not work for tiered partnerships and will not eliminate the opportunity for deferral. As such, the method proposed for tiered partnerships is to simply force all partnerships to adopt a co-terminus year end. The default rule for tiered partnerships is that those which have not elected to have a common fiscal period will to be deemed to have a fiscal period of December 31, starting in 2011.
The proposed rules allow for transitional relief under both options, in most instances. Generally, transitional relief will result in no additional taxes being payable in the corporate partner's first taxation year ending after March 22, 2011.
The transitional relief would essentially bring in the first year's additional income over a five-year (or possibly six-year) period through a reserve mechanism. The amount eligible for relief will be based on the corporate partner's qualifying transitional income. However, the transitional relief could be thrown offside if certain conditions aren't met, such that the corporate partner would not be entitled to take a reserve. Some of the circumstances in which the relief would not be available are when the partnership is dissolved or the corporate partner hasn't continuously been a member of the partnership since before March 22, 2011.
Planning points/unwanted traps
The proposed rules will not end the use of partnership structures entirely. There will still be planning opportunities available. For example, corporate partners may wish to take the ASPA path, as it would allow them to maintain somewhat of a deferral where partnership earnings are growing. However, if a partnership has been experiencing losses, an alignment election could accelerate the claim of those losses.
An opportunity will also exist for corporate partners to claim two years of losses in the first taxation year after March 22, 2011, through an alignment election. Note, however, that this option will not be available through the ASPA alternative, as an ASPA can never be a negative amount. The alignment election also provides for simplified recordkeeping for accounting and tax purposes for a group of related companies. However, taxpayers should note that this will be a one-time election with a specific due date, and if that date is missed, they may be out of luck.
The proposed rules will continue to provide the flexibility to flow a partnership's earnings and tax attributes through to its partners. However, the proposed rules will apply only to those partnerships with corporate partners that have a misaligned year-end.
Finally, the 1995 rules apply to partnerships with individuals as partners. Neither the 1995 rules nor the 2011 rules apply to trusts that have an interest in a partnership. Therefore, corporate partners may want to explore different ownership structures to leverage this inconsistency.
A word of caution
These proposed rules and the options available to corporate partners should be looked at sooner rather than later. There are specific deadlines for election filings and a short time to analyse options. If corporate partners don't act quickly, they could find themselves trapped.
Deepk Jaswal, CA, is a tax manager in the Private Company Services group with Deloitte & Touche LLP in Vancouver.