On June 21, 2011, Tax Executives Institute submitted comments to Canadian Minister of Finance James M. Flaherty on a June 6, 2011, Budget proposal that will limit the deferral of partnership income earned by corporate partners. The Institute’s comments were prepared under the aegis of the Canadian Income Tax Committee, whose chair is Carmine A. Arcari of the Royal Bank of Canada. Contributing substantially to the development of TEI's comments was Lynn A. Moen of Walton Group International, Inc., and Marvin E. Lamb of Imperial Oil Limited. Also contributing was Rodney C. Bergen of The Jim Pattison Group.
Original Submission
Magazine Article
On June 6, 2011, the government released a Budget message with draft legislative proposals to amend various provisions of the Income Tax Act, Canada (the Act). The tax proposals, including those ending deferral of corporate tax by corporate investors in partnerships, generally mirror those released on March 22, 2011. On behalf of Tax Executives Institute, I urge the Department of Finance to lengthen the transition relief period for the recognition of the deferred partnership income. In addition, we offer recommendations relating to “Under-Reported Stub Period Accrual” and “Single-tier Alignment Election.”
Tax Executives Institute
TEI is the preeminent international association of business tax executives worldwide. The Institute’s nearly 7,000 professionals manage the tax affairs of 3,000 of the leading companies in North America, Europe, and Asia. Canadians constitute 10 percent of TEI’s membership, with our Canadian members belonging to chapters in Calgary, Montreal, Toronto, and Vancouver, which together make up one of our nine geographic regions, and must contend daily with the planning and compliance aspects of Canada’s business tax laws. Many of our non-Canadian members (including those in Europe and Asia) work for companies with substantial activities in Canada. The comments set forth in this letter reflect the views of TEI as a whole, but more particularly those of our Canadian constituency.
TEI concerns itself with important issues of tax policy and administration and is dedicated to working with government agencies to reduce the costs and burdens of tax compliance and administration to our common benefit. In furtherance of this goal, TEI supports efforts to improve the tax laws and their administration at all levels of government. We believe that the diversity and professional training of our members enable us to bring a balanced and practical perspective to the issues raised by the June 6, 2011, partnership provisions.
Discussion
Under current rules, income earned by a corporation as a member of a partnership is included in the corporation’s income for the corporate taxation year in which the fiscal period of the partnership ends. If a corporation carries on a business through a partnership that has a fiscal period that ends after the end of the corporation’s taxation year, taxation of the partnership earnings can be deferred up to a year.
Annex 3 of the June 6, 2011, Budget describes and explains amendments to the Act and Income Tax Regulations, including proposals to eliminate deferral of partnership income by corporations.[1] Unlike other budget provisions, no draft legislation was released for the partnership proposals. The goal of the proposals, however, is clear: “to limit deferral opportunities for corporations with significant interests in partnerships."[2]
Generally, TEI agrees with the policy goal of the proposal. By limiting income deferral opportunities for corporations investing in partnerships that have a fiscal year end following the corporation’s year end, Canada’s tax system will align with other G7 and G20 countries. Without better transition rules, however, the required recognition of the deferred partnership income will adversely affect cash flows, potentially limiting capital spending and employment opportunities in Canada. Given the nascent economic recovery and the volatility of the global financial environment, TEI is concerned about the financial effects of the proposals on Canadian business taxpayers. (Our concerns are exacerbated by strength of the Canadian dollar, which has hindered the recovery of export-driven companies.) We also have concerns about the administrability of the proposal and urge the Department of Finance to consider the following comments when drafting the legislation.
A. Lengthen the Transition Period. Under the transition relief proposal, the partnership income for the period from the end of the partnership’s tax year through the end of the corporate partner’s taxation year (the “Stub Period Accrual”) will be included in the corporation’s income over five years. We urge the Department to provide a 10-year transition period for the Stub Period Accrual. Moving to a 10-year transition period would ease the tax burden of clawing back the deferred income and afford companies greater flexibility in managing their cash flow. Moreover, a 10-year transition period would be consistent with the relief provided in 1995 when deferral was eliminated for individuals that carried on business through a partnership or sole proprietorship.
TEI also recommends that transition relief be available to all corporate partners that owned a partnership interest as of March 22, 2011. The current proposal will not afford transitional relief to a corporate partner unless income is allocated to it from the partnership’s first taxation year that ends after that date. In other words, corporations that acquired a partnership interest before March 22, 2011, but after the end of the fiscal period of the partnership will not qualify for the transitional relief. Similarly, a corporation investing in a new partnership formed before the March 22, 2011, with a fiscal period ending after the corporate partner’s first taxation year after that budget date will not qualify for transitional relief. Instead, the corporate partners will include the income for the partnership’s fiscal period and the Stub Period Accrual in their taxation years ending in 2012. As a result, up to two full years of income may be taxed in the same year. This is a harsh result for companies that formed or acquired partnerships before the announced change. TEI recommends that the Department afford a reasonable transitional relief period for all partnerships formed or acquired before March 22, 2011, for which the first partnership year ends after that date.
B. Eliminate or Modify the “Under-Reported Stub Period Accrual” Calculation. The partnership deferral proposal includes two methods for calculating the “Stub Period Accrual”: a formulaic approach and a designation approach. The formulaic approach prescribes, in effect, a safe harbour for the amount of stub period income to be included in a partner’s corporate tax return. Taxpayers using the formulaic approach need not satisfy any additional requirements. Under the designation method, taxpayers may estimate the amount of the Stub Period Accrual income, subject to “verification . . . once the partnership’s fiscal period has ended."[3] In effect, a corporate partner must determine whether it has under-reported the Stub Period Accrual. Where the estimated amount designated by the partner is less than the lesser of the actual pro-rated income of the corporate partner from the partnership for the Stub Period and the amount determined under the formulaic approach, the corporate partner will be subject to an additional income inclusion in the following taxation year. In general, the additional income inclusion adjustment is equal to the amount of the shortfall multiplied by the average prescribed interest rate applicable for underpayments of tax. If, however, “the shortfall is larger than 25 per cent of the lesser of the pro-rated actual amount and the amount determined under the formulaic approach, there will be an additional income inclusion adjustment equal to 50 per cent of the additional income inclusion in respect of the amount of the shortfall in excess of the 25-per-cent threshold."[4]
TEI believes the additional income inclusion amount is excessive given the many events outside a corporate partner’s control that will affect the actual pro-rated amount of stub period income.[5] Concededly, there should be consequences for failing to estimate taxable income correctly, but the Under-Reported Stub Period Accrual income inclusion should be eliminated because, subject to clarification from the Department of Finance, we assume that the instalment interest rules will still apply to underpayments of tax attributable to underestimated stub period income. Stacking the proposed income inclusion on top of required instalment interest is unduly harsh. If the Department believes a minimum inclusion threshold is necessary to promote accurate estimates of the designated Stub Period Accrual, TEI recommends that the draft legislation require the use of the formulaic method in subsequent years whenever a corporation’s designated Stub Period Accrual estimate results in a shortfall in excess of 25 percent of the actual pro-rated income amount.
C. Eliminate the Time Limit for Making the “Single-tier Alignment Election” or Expand the Time to Make the Election. The proposal for limiting partnership income deferrals includes a one-time “Single-tier Alignment Election” that will permit a partnership to change its fiscal period.[6] The election’s availability, however, expires within a prescribed window following “. . . the last day of the first taxation year ending after March 22, 2011. . . ."[7] The tax policy or administrative reason for imposing a time limit on the election’s availability is unclear. More important, the narrow window for making the election does not afford companies sufficient time to review and assess the effects of the proposed rule changes and implement a plan to efficiently manage its effects. There will likely be many partnerships where one or more partners may not, for valid business reasons, wish to change the partnership year end within the prescribed period. Hence, TEI recommends that the Department either eliminate the time limit for making the election or expand the window for making the election to a minimum of three years.
Conclusion
TEI appreciates this opportunity to share our views on the partnership proposals and would be pleased to meet with representatives of the Department of Finance at their earliest convenience to discuss these comments and recommendations. TEI’s comments were prepared under the aegis of the Institute’s Canadian Income Tax Committee, whose chair is Carmine A. Arcari. If you should have any questions about the submission, please do not hesitate to call Mr. Arcari at 416.955.7972 (or carmine.arcari@rbc.com) or Rodney C. Bergen, TEI’s Vice President for Canadian Affairs, at 604.488.5231 (or Bergen@jp-group.com).
Respectfully submitted,
Tax Executives Institute
Paul O’Connor
International President
cc: Louise Levonian, Associate Deputy Minister, Tax Policy Branch
Brian Ernewein, General Director, Policy and Legislation, Department of Finance
Gérard Lalonde, Director, Tax Legislation, Department of Finance
Rodney C. Bergen, TEI Vice President for Canadian Affairs
Carmine A. Arcari, Chair, TEI Canadian Income Tax Committee
[1] The Next Phase Of Canada’s Economic Action Plan, A Low-Tax Plan For Jobs And Growth. Annex 3 Tax Measures: Supplementary Information, Notices of Ways and Means and Draft Amendments to the Income Tax Regulations (June 6, 2011).
[2] Id. at 314.
[3] Id. at 318.
[4] Id. at 319.
[5] If TEI’s recommendations to lengthen the transition period relief to 10 years and provide transition relief to all partnerships were adopted, most taxpayers would likely be willing to forgo use of the designated income method in favor of the formulaic method. Hence, the legislation could be simplified by eliminating the designated income method.
[6] The partnership proposal does not describe the effect of losses incurred during the stub period. Partnerships incurring losses in the stub period should not be precluded from making appropriate elections nor should they be denied appropriate relief. We recommend that the Department of Finance address the treatment of losses in the draft legislation and Explanatory Notes.
[7] Budget Annex 3 at 319.