Companies in the real estate industry with interests in partnerships may be affected by tax changes announced in the 2012 federal budget. These changes may have adverse tax implications for certain types of acquisitions, dispositions and financing arrangements. Companies involved in these types of transactions may, however, be able to take steps to minimize adverse tax consequences resulting from the budget changes.
Partnerships are commonly used in the real estate industry for several reasons, including their flow-through nature and flexibility in structuring transactions. Companies participating in partnership transactions involving real estate should consider whether the budget changes will affect the tax implications of their transactions.
Transactions that could be affected include:
- Acquiring a subsidiary corporation that has an interest in a partnership and amalgamating or winding up the subsidiary with the parent corporation
- Disposing of a partnership interest to a tax-exempt entity (e.g., a pension fund) or a non-resident person, either directly or indirectly as part of a series of transactions
- Non-resident financing of a partnership when the non-resident is a shareholder of a Canadian company that is a partner in the partnership.
This post summarizes the tax changes affecting these transactions. Real estate companies in general (and the people who manage or oversee their tax and financial functions in particular) may want to assess how they may be affected by these rules and consider taking action to mitigate their impact. The Quebec and Saskatchewan provincial budgets for 2012 also included tax measures that may affect the real estate industry - see below for details.
Federal tax changes
Partnership interest bump denied
A Canadian corporation (the Parent) that has acquired control of another Canadian corporation (the Subsidiary) is permitted to increase the cost base of certain non-depreciable capital property, including a partnership interest, acquired by the Parent on a vertical amalgamation with or wind-up of the Subsidiary.
Before the 2012 federal budget, the Parent may have been able to "bump" the cost base in a partnership that holds ineligible income assets, effectively transferring the purchase price of the shares to the cost of the partnership interest, which could later be disposed. Ineligible income assets would generally include assets that, if sold, could produce income (as distinguished from producing only capital gains), which may include real estate properties under development, bare lands, depreciable property such as buildings and leasehold interests, real estate held in inventory of a business and real estate held for resale.
The budget proposes to deny a bump for a partnership interest to the extent that the accrued gain in the partnership interest is reasonably attributable to the amount by which the fair market value of the ineligible income assets held by the partnership exceeds their cost amount.
The proposed measure would apply to amalgamations that occur, or wind-ups that commence, on or after March 29, 2012, subject to limited grandfathering.
Sale of partnership interest to a tax-exempt or non-resident entity
Income assets held by a partnership are fully taxable on the direct transfer of the partnership interest by a taxpayer to a tax-exempt person so as to prevent the conversion of income gains (including recapture of previously claimed capital cost allowance) into capital gains. Tax-exempt persons include pension funds, non-profit organizations, and Crown corporations. The budget proposes to clarify that this rule applies to dispositions made directly, or indirectly as part of a series of transactions, to tax-exempt persons.
In addition, this measure expands the scope of existing legislation to include dispositions made directly, or indirectly as part of a series of transactions, to non-resident persons. Previously, a taxpayer could have disposed of a partnership interest that holds income assets or depreciable capital property with potential recapture to avoid income inclusions that would be exempt from Canadian income tax in the hands of a non-resident under either domestic law or a tax treaty.
The Department of Finance has proposed to enhance the existing legislation that applies to tax-exempt persons to also apply to the disposition of partnership interests to non-resident persons. That is, gains on income assets and recapture on depreciable capital property, including buildings held by the partnership, will be fully taxable. However, the provisions will not apply to a partnership that continues to carry on business in Canada through a permanent establishment in which all of the partnerships assets are used in Canada. In such cases, the partnership's income assets would remain within the Canadian income tax net.
These measures may have a significant impact on dispositions of real estate partnerships.
This proposed measure would apply to dispositions of partnership interests that occur on or after March 29, 2012. Exceptions would be made for arm's length dispositions made before 2013 for which a written agreement exists before March 29, 2012.
Thin capitalization and partnership debts
It is not uncommon in Canada for real estate companies to be financed by a non-resident lender. Existing rules limited the deduction of interest on debts issued by certain non-residents where the amount of debt exceeds a 2-to-1 debt-to-equity ratio. This rule applies to debts owing to a specified shareholder of a corporation (a person or group owning shares representing more than 25% of the votes or value of the corporation).
The budget proposes to extend the thin capitalization rules to debts owed by partnerships of which a Canadian-resident corporation is a member. To further limit the amount of deductible interest, the budget proposes to reduce the debt-to-equity ratio from 2-to-1 to 1.5-to-1.
Under the proposals, the corporate partner will include its proportionate share of partnership debt in computing its debt-to-equity ratio. Rather than denying the interest deduction at the partnership level, an amount will be included in computing the income of the partner from a business or property, as appropriate.
These proposed measures would apply effective March 29, 2012, subject to prorating for taxation years that include that day.
Provincial tax changes
Quebec budget targets real estate trusts
The 2012 Quebec budget contained proposals to tighten its tax legislation applicable to inter vivos trusts. The budget measures ensure that inter vivos trusts are generally subject to the highest marginal tax rate of 24% (up from 20%) and that tax applies to rental income earned and capital gains realized from rental properties located in Quebec.
The budget deems a non-resident inter vivos trust that becomes a resident of Canada to dispose of its rental immoveable properties immediately before becoming a resident of Canada. To ensure that Quebec tax is paid on any future capital gains resulting from this deemed disposition, the trust will have to obtain a certificate of compliance from Quebec before actually disposing of a Quebec rental property that it owned when it changed residency. The purchaser of this Quebec immoveable property could be held liable for the Quebec tax, to a maximum of 12% of the purchase price of the property, if a certificate is not received.
The proposed amendments will apply to inter vivos trusts that become a resident of Canada on or after March 20, 2012.
Saskatchewan introduces tax break for real estate
The 2012 Saskatchewan budget introduced a tax rebate that will reduce by 10% the general corporate income tax rate on income earned from the rental of newly constructed, qualifying multi-unit residential projects. While the rebate is available for 10 consecutive years based on the eligible corporation's fiscal year-end, the corporation may defer eligibility for the tax rebate until the initial year the new housing project is complete and ready for occupancy.
Rental housing that is registered under a building permit dated on or after March 21, 2012 and before January 1, 2014 will be eligible for the tax rebate, up to a maximum of 10,000 rental units. Eligible units must be constructed and available for rent before the end of 2016.
Information is current to May 8, 2012. The information contained in thisBlog Postis 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.
Pav Sikham, CA
Senior Manager, Tax
777 Dunsmuir Street
PO Box 10426 Pacific Centre
Vancouver, BC V7Y 1K3
T 604 646 6440
F 604 691 3031