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September 15, 2011 No. 2011-26
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Corporate Partnerships Lose Tax Deferral Corporations that carry on business in partnership may have to comply with complex new rules designed to eliminate their ability to defer corporate tax by selecting a fiscal period for the partnership that differs from the corporate partners’ taxation years. The Department of Finance released draft legislation on August 16, 2011 to implement these new rules, which were proposed in the 2011 federal budget. The draft legislation (and Explanatory Notes released September 1, 2011) generally implement the budget proposals as conceived but they also clarify certain concepts and contain some unexpected changes. Finance is accepting comments on the draft legislation but only until September 16, 2011. It is not clear whether this short deadline will be extended. Inside this Issue This TaxNewsFlash-Canada provides an overview of the corporate partnership proposals in the following areas: · Highlights of the new rules · Adjusted stub period accrual · Reserve mechanism · Qualifying transitional income · Illustrative example of the new rules · Under-reported stub period accrual · Election to change a partnership’s fiscal period · Special rule for new corporate partners · Multi-tier partnerships · Implications for joint ventures Highlights of the new rules The budget proposals limit the tax deferral opportunities for corporations with significant interests in partnerships that have a fiscal period different from the corporations’ taxation years. The proposals apply to corporations’ taxation years ending after March 22, 2011.
In general, a corporation has a “significant interest” in a partnership if the corporation (together with related or affiliated persons or partnerships) is entitled to more than 10 percent of the income or loss of the partnership or the assets (net of liabilities) of the partnership on its dissolution. The proposed measures require the corporation to include not only the income of the partnership for the fiscal period that ends in the corporation’s taxation year, but also to accrue partnership income for a stub period of the partnership’s subsequent fiscal period which begins in the corporate partner’s taxation year and ends in the following one. This income is known as the “adjusted stub period accrual”. This adjusted stub period accrual is reversed in the following taxation year and a new one is calculated and included in income. These measures could result in the inclusion of significant incremental partnership income for a corporation’s first taxation year ending after March 22, 2011. To mitigate the potential cash-flow impact of accruing a partnership’s stub period income, transitional relief will generally be available to recognize the incremental amount gradually over the five taxation years that follow the corporation’s first taxation year that ends after March 22, 2011. Income exempt from
the new rules The new rules will also not apply to a corporation that is bankrupt. KPMG observation These exclusions did not appear in the budget proposals but are sensible as different tax policy considerations apply in these cases. As currently drafted, the new rules apply to the computation of hybrid surplus of a foreign affiliate, a new concept introduced by draft legislation on August 19, 2011 (see KPMG’s TaxNewsFlash-Canada 2011-24, “Foreign Affiliate Tax Rules Get a Make-Over”.) Adjusted stub period accrual A corporation’s adjusted stub period accrual is determined by a three-part formula, essentially A minus (B plus C). In general, A is a pro-ration over the stub period of the partnership that ends in the corporation’s taxation year of: · the corporation’s share of the partnership’s income and taxable capital gains (other than dividends for which a deduction is available) · less the corporation’s share of the partnership’s losses and allowable capital losses (to the extent of taxable capital gains). B is an amount of qualified resource expenses designated by the corporation for the year in its return of income for the year. C is a discretionary amount of stub period accrual designated by the corporation in its return of income for the year (other than for qualified resource expenses). The designation is intended to allow a corporate partner to reduce its stub period accrual to reflect its knowledge of the actual partnership income for the stub period. Qualified resource expenses consist of Canadian exploration expenses, Canadian development expenses, foreign resource expenses and Canadian oil and gas expenses. They can be designated only to the extent that the corporation obtains from the partnership before the corporation’s filing-due date for the year information in writing identifying the qualified resource expenses. KPMG observation It does not appear that the designation for qualified resource expenses contemplates a disposition by a partnership of a particular resource property or the proper integration of successor resource deduction rules. No loss accrual
from partnership for stub period Character of stub
period accrual KPMG observation Many tax attributes of a corporation may be affected by the inclusion of adjusted stub period accrual in a taxation year and its subsequent deduction in the following year. For example, refundable dividend tax on hand, general rate income pool, low rate income pool, safe income and the adjusted cost base of the partnership interest may be affected. As a result, certain rules deem the components of the adjusted stub period accrual to retain their character to mitigate distortion of such tax attributes. Reserve mechanism As partnership income for more than one fiscal period may be included in income for a single taxation year of the corporation under the draft legislation, transitional relief is provided via a reserve mechanism to mitigate cash flow problems that otherwise could have resulted from the additional tax burden. In particular, in certain circumstances, a corporation is allowed to include in income the additional adjusted stub period income gradually over the five taxation years that follow its first taxation year ending after March 22, 2011. Where the transitional rules apply, the corporation may deduct as a reserve the “specified percentage” for the particular taxation year of the corporation’s “qualifying transitional income” from the partnership (discussed below). For these purposes, “specified percentage” generally means: · 100 percent for 2011 · 85 percent for 2012 · 65 percent for 2013 · 45 percent for 2014 · 25 percent for 2015. In effect, the reserve is included in income starting with 15 percent in 2012, 20 percent in each of 2013, 2014 and 2015 and the remaining 25 percent in 2016. Depending on the circumstances, a corporation eligible for transitional relief may realize qualifying transitional income in its 2012 or 2013 taxation years. In such a case, the specified percentage is modified accordingly. Qualifying transitional income “Qualifying transitional income” includes “adjusted stub period income” of the corporation from the partnership for the corporation’s first taxation year ending after March 22, 2011. Further, if a single-tier alignment election is made (discussed below) and a partnership has a second fiscal period that ends in a corporate partner’s first taxation year ending after March 22, 2011, the corporation will have “eligible alignment income” for such period, which is included in qualifying transitional income. A corporation has qualifying transitional income only if the corporation is a member of the partnership on March 22, 2011. KPMG observation A corporation that joins an existing partnership or forms a new partnership after March 22, 2011 will not have qualifying transitional income and thus will not be eligible for transitional relief. Rules for
calculating transitional income For these purposes, the income or loss of the partnership for a fiscal period is generally computed as if the partnership deducted the maximum amount of any expense, reserve, allowance or other amount and elected not to include in income any amount for work-in-progress. KPMG observation The requirement to deduct the maximum amount of any “expense” in computing qualifying transitional income is unexpected.
It still appears to be possible, however, for a corporate partner to maximize its qualifying transitional income by forgoing a deduction of designated resource expenses in computing adjusted stub period accrual for its first taxation year ending after March 22, 2011. Adjustment to
transitional income The particular year is normally the taxation year immediately following the taxation year in which the corporation’s qualifying transitional income is first determined, unless one or more short taxation year-ends precede the fiscal period-end of the partnership. Reserve for
qualifying transitional income · At the end of the partnership’s fiscal period that begins before March 22, 2011 and ends in the year of the corporation that includes March 22, 2011, · At the end of the partnership’s fiscal period commencing immediately after such fiscal period and until after the end of the year of the corporation that includes March 22, 2011, and · Continuously since before March 22, 2011 until the end of the year. An anti-avoidance rule disallows a corporation an entitlement to a reserve if it is reasonable to conclude that one of the main reasons the corporation is a member of a partnership in a taxation year is to avoid the rules that prohibit a reserve. KPMG observation It is unclear in which circumstances the anti-avoidance rule will apply to a disposition by a corporate partner of only a portion of its interest in a partnership, as there is no safe harbour threshold. Relieving rule KPMG observation The relieving rule is intended to ensure that internal reorganizations do not result in a forfeit of transitional relief. However, as noted below, this relieving rule may be ineffective in certain circumstances. Situations where a
reserve is not available Further, the reserve is not available if the corporation’s taxation year ends immediately before another taxation year at the beginning of which the partnership no longer principally carries on activities to which the reserve relates, in which the corporation becomes bankrupt, or in which the corporation is dissolved or wound up (other than a tax-deferred wind-up). KPMG observation An amalgamation might be used instead of a disqualified wind-up to preserve the ability to deduct the reserve.
The word “activities” is broad enough to cover carrying on a business and holding property. It is unclear, however, whether the partnership must carry on the “same activities” throughout the transition period to meet the test (i.e., carry on the very same business or hold the very same property).
The requirement that the partnership principally carry on the “activities” to which the reserve relates also may impair the ability to deduct a reserve for the portion of qualifying transitional income that relates to a taxable capital gain realized on a one-time disposition of capital property outside the ordinary course of business.
The “principally” test also raises the question of whether a corporation could potentially lose its entitlement to the reserve due to an amalgamation, acquisition or through organic growth. Guidance from Finance or the CRA will be needed on whether the “principally” test is a test of revenue, assets, income or some combination of these amounts. Including the
reserve in the following year’s income A further reserve is deductible in that following taxation year, generally in the amount of the least of the specified percentage for the particular year of the corporation’s qualifying transitional income, the amount of the reserve added back into income for the year, and the corporation’s income for the particular year computed before deducting any amount as a reserve. KPMG observation While the reserve is deductible at the option of the corporation, if no amount is deducted as a reserve in a particular taxation year, the corporation will forfeit the reserve deduction for the rest of the transition period.
The amount of the reserve that is deductible is limited to the income of the corporation for the taxation year from all sources computed before the deduction of the reserve.
This rule has several consequences, some of which appear to be unintended:
· If a corporation incurs a loss in a particular year, no amount will be deductible as a reserve in the particular year or, consequently, thereafter in the transition period. This result is principled because, in that case, the full amount of qualifying transitional income will have been included in income in the loss year without triggering additional tax payable that would affect cash flow.
· If a corporation has a short taxation year due to an amalgamation or acquisition of control, the corporation’s income for the short year could potentially be lower than the maximum reserve available, thus restricting reserve claims for the short year and future years.
· The relieving rule for an internal reorganization may be ineffective where the only or major source of a corporation’s income is its interest in a partnership. Once this corporation transfers this source of income to an affiliated or related party, its reserve claims could be restricted. Illustrative example of the new rules The following example illustrates the adjusted stub period accrual and the transitional reserve for a corporate partner. Assume:
· A corporation (Corporate Partner) owns a greater than 10 percent interest in a partnership (Partnership) · Corporate Partner has a December 31 year-end · Partnership has a January 31 fiscal period · Corporate Partner’s share of Partnership’s taxable income is: $1.2 million for Partnership fiscal period ended January 31, 2011 $1.5 million for Partnership fiscal period ended January 31, 2012 $2.4 million for Partnership fiscal period ended January 31, 2013.
Notes
1. In the above example, Corporate Partner is effectively required to initially include 23 months of income from Partnership ($1.2m and $1.1m) in its taxation year ended December 31, 2011. Corporate Partner is then allowed to claim a $1.1m qualifying transitional reserve in 2011.
2. The qualifying transitional reserve of $1.1m claimed in 2011 is “trued-up” for Corporate Partner’s 2012 taxation year to $1.375m at the end of the period (i.e., actual income for the February 1, 2011 to December 31, 2011 stub period computed as $1.5m × 11/12). 3. Technically, the proration factor is based on the number of days in the fiscal period. For ease of illustration, we have shown the proration based on a monthly proration. Under-reported stub period accrual Under the draft legislation, if a designation is made that results in an income shortfall, the corporation may be required to include in income in the following taxation year an additional amount determined by a formula that consists of an income shortfall adjustment and a penalty. This rule deters an excessive designation to defer the recognition of adjusted stub period accrual. KPMG observation The “income shortfall adjustment” is computed by reference to prescribed rates, which are currently very low. Accordingly, without an additional deterrent, a corporate partner that earns returns on capital higher than the prescribed rates or operates in a highly inflationary environment may prefer to designate an amount of stub period accrual to take advantage of the deferral opportunity. The penalty component of the additional income deters the deferral of too much partnership income by way of a designation, especially where the actual pro-rata income of the partnership for the stub period is unknown.
A corporate partner may offset an over-reported stub period accrual for one partnership against an under-reported stub period accrual of another partnership to avoid or reduce the additional income inclusion and penalty.
KPMG observation More cautious taxpayers and corporate partners of partnerships with “lumpy” or unpredictable income may prefer not to designate amounts to avoid the threat of the additional income inclusion.
The designations for each of the stub period accrual and qualified resource expenses cannot be amended or revoked. This rule prohibits the use of hindsight to change a designation to avoid an additional income inclusion for under-reported stub period accrual. Election to change a partnership’s fiscal period The draft legislation permits, in certain circumstances, corporate partners of a partnership to elect to change the fiscal period of the partnership to align to the taxation year of one or more of the corporations. If, by reason of the election, a corporate partner has a taxation year that coincides with the fiscal period of the partnership, the corporation may compute income from the partnership under existing rules and thereby avoid the complexity of the draft legislation. Corporate partners, however, often have different taxation year-ends. If so, the election can be used to align the fiscal period of the partnership to only one of those taxation years. The corporate partners that have a taxation year that is different from the newly elected fiscal period of the partnership will be required to apply the draft legislation to accrue income from the partnership for the stub period of the partnership that falls in such corporation’s taxation year. A partnership may elect to change its fiscal period to align with the taxation year of one or more of its corporate partners under a one-time “single-tier alignment election” but only if certain conditions are met, including: · Only one election is filed in writing in prescribed form by a corporation that is a member of the partnership on or before the day that is the earliest filing due-date of any corporation that is a member of the partnership for its first taxation year ending after March 22, 2011, · The fiscal period of the partnership to which the election applies is not more than 12 months, and · The election was made by a corporation with authority to act for the members of the partnership. KPMG observation In an apparent departure from the budget proposals, under the draft legislation, a single-tier alignment election can be made even if the partnership incurs a loss.
The deadline to make a single-tier alignment election is short. As noted above, the election must be filed by a corporate partner on or before the day that is the earliest filing-due date of any corporation that is a member of the partnership for its first taxation year ending after March 22, 2011. Special rule for new corporate partners A special rule applies to a corporation that acquires a significant interest in a partnership during a fiscal period of the partnership that begins in the corporation’s taxation year and ends on or before the filing-due date for the taxation year. The special rule is intended to permit a new corporate partner to apportion its income from the partnership between its two taxation years straddled by the fiscal period of the partnership. Under the special rule, the corporation may at its option include in income a designated amount up to its pro-rated income from the partnership (other than dividends for which a deduction is available) for the stub period. KPMG observation Unlike “adjusted stub period accrual,” the upper limit of the designated amount is computed by reference to the corporation’s “income from the partnership”; this appears to refer to the amount of partnership income allocated to the corporation under the existing rules rather than the proposed rules. Income inclusion
deductible in the following year The income inclusion under the special rule is not included in qualifying transitional income, and so no reserve is available for the amount. KPMG observation As the income inclusion under the special rule is optional, a corporation may decline to include any amount in income and thereby defer corporate tax on the income of the partnership for the stub period without the risk of incurring a penalty for under-reported stub period accrual.
A new corporate partner is generally advised to defer corporate tax on the income from the partnership for the stub period. A corporation may wish, however, to designate an income inclusion under the special rule if it needs to use non-capital losses or tax credits in the taxation year that otherwise would expire. Multi-tier partnerships New rules require a partnership to adopt a calendar fiscal period in certain circumstances. A partnership that is a member of a tiered partnership structure (other than a partnership having a professional corporation as a member or a partnership that makes a “multi-tier alignment election,” as discussed below) is generally required to have a calendar fiscal period under certain circumstances. Multi-tier
alignment election Implications for joint ventures A joint venture is not an entity or a partnership, but is instead a relationship formed by an agreement. Therefore, each participant must report its proportionate interest in the assets and operations of the joint venture. Joint venture ownership arrangements are commonly used in the real estate and oil and gas industries. Real estate investors often have many joint venture investments, each representing a proportionate interest in real estate (for example, rental property or residential real property development). The CRA has publicly stated that the 2011 federal budget proposals to limit the tax deferral opportunities available to certain corporations requires that it change its existing administrative position that allows a joint venture to establish a fiscal period that differs from the fiscal periods of the joint venture participants. The CRA says it would not be appropriate to allow a deferral through a joint venture that is not available through a partnership. Thus, joint venture participants will no longer be eligible to compute income as if the joint venture had a separate fiscal period. The CRA also said it would offer “transitional relief” for joint ventures that will be consistent with the transitional relief available to members of a corporate partnership and that it would consult with affected taxpayers prior to providing detailed guidance in writing. KPMG observations The elimination of the ability for a joint venture to adopt a fiscal year-end for reporting to its owners may create an onerous administrative burden for the joint venture. In particular, the joint venture will be required to prepare joint venture financial reporting for each joint venture participant that has a fiscal period that differs from the joint venture.
We hope the CRA will allow a joint venture to keep a different fiscal period and instead require joint venture participants to include an amount in their income that reflects the equivalent of a “stub period accrual” that applies to a corporate partner. We can help Your KPMG adviser can help you assess the effect of the complex new corporate partnership proposals on your business, and point out ways to take advantage of any benefits arising from the proposals or help mitigate their impact. For more details on these measures and their potential impact, contact your KPMG adviser.
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Information is current to September 14, 2011. 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/ © 2011 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.
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