January 20, 2012
If your real estate company is involved in any partnership in which it has a significant interest or any joint venture project, it may be affected by new rules that limit the tax deferral opportunities if the partnership or joint venture has a fiscal period different from your corporation’s taxation year.
Tax directors of real estate companies affected by these rules may want to consider taking action to mitigate their impact. These actions may include filing an election to change a partnership’s fiscal period. Some companies will only have until January 31, 2012 to file this election, so these companies will need to act quickly to take advantage of this opportunity, if it is appropriate for them.
This edition of TaxNewsFlash-Canada discusses the implications of the new partnership anti-deferral rules on real estate development partnerships, dispositions of real estate, rental property partnerships and real estate joint ventures, including a discussion of options to manage a joint venture’s additional tax compliance burden.
New rules limit the tax deferral opportunities for corporations with significant interests in partnerships that have a fiscal period different from the corporations’ taxation years. These partnership anti-deferral rules apply to corporations’ taxation years ending after March 22, 2011.
See KPMG’s TaxNewsFlash-Canada 2011-26, “Corporate Partnerships Lose Tax Deferral” for a complete analysis of the new partnership anti-deferral rules.
These new rules require a corporation to accrue deferred partnership income (the adjusted stub period accrual) in addition to the income of the partnership for the fiscal period that ends in the corporation’s taxation year. Therefore, there may be an inclusion of significant incremental partnership income for a corporation’s first taxation year ending after March 22, 2011 (the transitional year). To mitigate the potential cash-flow impact of the initial adjusted stub period accrual, transitional relief may be available through a reserve, which effectively results in the recognition of the incremental income over the five taxation years that follow the transitional year.
These rules apply to a corporation that owns a significant interest in a partnership. A corporation has a significant interest in a partnership if the corporation, together with affiliated or related parties, is 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 corporation’s taxation year.
Adjusted stub period accrual is calculated by a formula that pro-rates the partnership’s income for its fiscal period that ended in the corporation’s taxation year over the remainder of the corporation’s taxation year. However, the corporation may designate an amount to reduce this adjusted stub period accrual. The designation to reduce adjusted stub period accrual recognizes that the corporation may know or expect that the actual income of the partnership for the stub period will be lower than the adjusted stub period accrual computed under the formulaic approach. If the designation results in an underestimate of its share of the actual partnership income for the stub period, the corporation may be required to include in taxable income in its subsequent taxation year the income shortfall adjustment and a penalty amount computed as an interest charge on the under-accrued partnership income.
Certain corporate partners may wish to change the fiscal period of a partnership to avoid the accrual obligation and the resulting compliance burden. The corporate partners of a single-tier partnership may elect to change the fiscal period of the partnership in limited circumstances. Partnerships that are part of a multi-tiered partnership structure must adopt a calendar fiscal period, unless all of the partnerships in the structure elect otherwise. This multi-tier alignment election is available in certain circumstances only. Some or all of the partnership’s income accelerated and allocated to the corporation under these alignment elections may be eligible for the transitional reserve.
A single-tier or a multi-tier alignment election is due by the earliest filing due date for the transitional year of any of the affected corporate partners. However, on December 16, 2011, the Department of Finance announced its intention to provide a short extension of time for corporate partners to late-file these alignment elections if filed on or before January 31, 2012.
Transitional relief is denied if the partnership no longer principally carries on the activities to which the reserve relates. This reserve denial rule may influence the decision to make a single-tier or multi-tier alignment election.
Real estate development partnershipsA partnership that develops real estate may earn development income in a single fiscal period or perhaps over two fiscal periods. Under the partnership anti-deferral rules, a corporate partner of a real estate development partnership may still defer all or a portion of its share of the income of the partnership, for two reasons.
First, adjusted stub period accrual is calculated based on the income realized by the partnership for the fiscal period of the partnership ending in the taxation year of the corporation. Thus, where the partnership earns nominal income in the fiscal period of the partnership ending in the taxation year of the corporation, the adjusted stub period accrual should be nominal. This is so even if the partnership earns substantial development income in the stub period.
Second, the corporation may make a designation to reduce adjusted stub period accrual. It is possible that the year-over-year development income realized by the partnership is “lumpy”, i.e., it is not consistent from year to year. If the partnership realizes development income in a fiscal period of the partnership that falls within the corporation’s taxation year, but expects losses or substantially reduced income in the stub period, the corporation may use a designation to reduce its adjusted stub period accrual. For example, if the corporation expects the partnership to earn all of the development income in a single fiscal period of the partnership that falls within the corporation’s taxation year, the corporation may designate and thereby reduce its adjusted stub period accrual in respect of the partnership in that year to nil without the risk of any significant interest charge on under-accrued partnership income in a subsequent taxation year.
Each corporate partner of the partnership should also consider its entitlement for transitional relief. In this regard, the corporation may wish to consider whether to make a single-tier or multi-tier alignment election. The election may accelerate the corporation’s recognition of development income earned by the partnership which is eligible for transitional relief.
The reserve denial rule also must be considered. The reserve should be available if the partnership continues to develop real estate throughout the five-year transitional period. The partnership must principally carry on the activities to which the reserve relates, which may include fulfilling the obligations under warranty contracts or providing letters of credit or other guarantees for obligations of the partnership.
Finally, these new rules only apply to a corporate partner that has a significant interest in a partnership. Therefore, a corporate partner that is not related or affiliated with the other partners and that is entitled to 10% or less of the income or loss of the partnership or net assets of the partnership on liquidation may still benefit from income deferral planning opportunities with a careful selection of fiscal year-ends.
Dispositions of real estate
The same analysis applies equally to partnerships that earn income and taxable capital gains from the disposition of real estate. The mechanisms that govern the accrual obligation for “lumpy” development income earned by a partnership likewise apply to the accrual obligation that accompanies one-time or non-recurring income realized by a partnership from a disposition of real estate.
However, if a corporation realizes income eligible for transitional relief, the application of the reserve denial rule should be considered. The corporation may lose the transitional reserve if the activities of the partnership have ceased on the disposition of the real estate. This result may arise where a single-purpose partnership disposes of all of its real estate, but not where a partnership holds a portfolio of real estate properties and disposes of only some of those properties.
These considerations may influence whether corporate partners should make a single-tier or a multi-tier alignment election.
Where partnerships are used as vehicles to invest in income-producing properties, such as commercial or residential rental properties, the partnership anti-deferral rules may not have a significant impact, particularly if the income is steady from year to year. In this respect, a corporation may consider whether a single-tier election or multi-tier election can help to reduce the complexities and uncertainties associated with the requirement to accrue stub period income and the additional cost of such a compliance burden.
In the context of rental partnerships that are expected to experience a steady increase in income year after year (for example, where a partnership is acquiring real estate), the rules allow a small measure of deferral under the formulaic approach to computing the adjusted stub period accrual. Thus, in these circumstances, it may not be beneficial to make a single-tier or a multi-tier alignment election. Conversely, if income of the rental partnership is expected to steadily decrease year after year, a single-tier or a multi-tier alignment election may be advantageous to avoid accelerating the income inclusion under the formulaic approach to computing the adjusted stub period accrual.
Real estate joint ventures
Joint ventures are commonly used in the real estate industry. Whereas the term “joint venture” may be used to refer to various forms of legal ownerships in real estate such as a partnership or a corporation, the focus of this discussion is restricted to a co-ownership of real estate including a joint tenancy or tenancy-in-common which is not treated as a separate entity for tax purposes.
Until recently, the Canada Revenue Agency (CRA) maintained a long-standing administrative policy to permit a joint venture to adopt a fiscal period that differs from its joint venture participants. Under that policy, the joint venture participants would include income relating to the fiscal period of the joint venture in the taxation year of the corporation in which the fiscal period of the joint venture ended. The policy treated joint ventures in the same manner as partnerships.
On November 29, 2011, the CRA announced that joint ventures will no longer be allowed to have a separate fiscal period. For taxation years ending after March 22, 2011, income from a joint venture must be calculated for each joint venture participant based on the taxation year of the particular participant. The CRA’s revised policy applies to all participants in a joint venture, whether or not they hold a significant interest in the joint venture. In this regard, a participant in a joint venture is now treated more harshly than a corporate partner in a partnership.
The CRA stated that joint venture participants who relied on its previous administrative position will be allowed transitional relief on an administrative basis. This relief is consistent with that available to a corporate partner of a partnership under the new legislation and subject to the same conditions (including the reserve denial rule). The CRA will allow a reserve deduction of 100% of the initial accrual of joint venture income for 2011, with the incremental income being brought into income of the participant gradually over its 2012 to 2016 taxation years.
The CRA has stated that transitional relief will not be available to a partnership that participates in a joint venture.
To claim transitional relief for joint venture income in its first taxation year ending after March 22, 2011, a joint venture participant must file an election in writing on or before the filing due date for that taxation year. The letter may be attached to the participant’s return of income for the transitional year. If a return has already been filed, the participant may send the letter to its Taxation Centre separately. Given the administrative burden and the accounting information required by a joint venture to comply with the new policy, we hope the CRA will extend the deadline to make the election for transitional relief.
Further administrative relief from the CRA
KPMG and the CRA have discussed certain aspects of the CRA’s revised policy. The CRA advised us that it is willing to grant further administrative relief, as follows:
- If capital cost allowance (CCA) is computed at the joint venture level and more than 12 months of joint venture income is recognized by a participant for tax purposes, the CRA will allow the joint venture to deduct more than 12 months of CCA.
- If the requisite accounting cannot be completed by the participant’s filing due date, an election for transitional relief may specify a reasonable estimate of the income eligible for transitional relief, and the estimate may be amended once actual stub period income of the joint venture is ascertainable.
Options to manage joint ventures’ additional compliance burden
Under the CRA’s new administrative policy, the joint venture must compute its income for the taxation year of each of its participants. This policy creates a significant additional compliance burden if the participants do not have the same taxation year-end or if such taxation year-ends do not coincide with the accounting reporting period of the joint venture. It may be prudent to consider alternatives to manage that compliance burden, such as the following:
- The taxation year-end of the participant may change to align to the reporting period of the joint venture. In this regard, the CRA generally requires that a change in the taxation year of a corporation be made prospectively but not retroactively.
- The reporting period of the joint venture may change to align to the taxation year-end of the (majority of) the corporate participants.
- The accounting reporting period of the joint venture and its participants are not aligned, but set to fall on a common quarter-end (to better distribute the accounting workload throughout the year and to enhance the frequency and quality of the financial reporting of the joint venture and its participants).
- The joint venture may convert into a partnership on a tax-deferred basis. In this way, the partnership anti-deferral rules will apply without having to rely on the CRA’s administrative policy on joint ventures. However, the reserve denial rule must be considered as it is unclear whether transitional relief will be available if the joint venture ceases to exist.
Your KPMG adviser can help you assess the effect of the complex partnership anti-deferral rules on your business and point out ways to take advantage of any benefits arising from the rules or help mitigate their impact. For more details on these measures and their potential impact, contact your KPMG adviser.
Information is current to January 18, 2012. The information contained in this TaxNewsFlash-Canada is of a general nature and is not intended to address the circumstances of any particular individual or entity. Although we endeavour to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. No one should act upon such information without appropriate professional advice after a thorough examination of the particular situation. For more information, contact KPMG’s National Tax Centre at 416.777.8500.
KPMG LLP, the audit, tax and advisory firm (kpmg.ca), a Canadian limited liability partnership established under the laws of Ontario, is the Canadian member firm of KPMG International Cooperative (“KPMG International”). KPMG International’s member firms have 140,000 professionals, including more than 7,900 partners, in 146 countries.
The independent member firms of the KPMG network are affiliated with KPMG International, a Swiss entity. Each KPMG firm is a legally distinct and separate entity, and describes itself as such.
KPMG's Canadian web site is located at http://www.kpmg.ca/
© 2012 KPMG LLP, a Canadian limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved.
The KPMG name, logo and “cutting through complexity” are registered trademarks or trademarks of KPMG International.