Principal Issues: [TaxInterpretations translation] What is the tax treatment for a partner who gradually withdraws over a five-year period and where the partner’s units in the partnership are redeemed at a rate of 20% per year?
Position: Where the partnership redeems 20% of the partner's units in the first year, the partner must include a gain of $270,000 in the year of redemption.
Reasons: Under subsection 40(1), a gain of $200,000 must be included in computing the partner's income. Pursuant to subsection 100(2), an additional $70,000 will also be added in computing the partner’s gain from the partial disposition of the partner’s interest.
FEDERAL TAX ROUNDTABLE
APFF CONFERENCE 2010
Question 40
Withdrawal from a partnership and negative adjusted cost base
A partnership agreement provides for the issuance of units to the partners. It also provides for a five-year withdrawal period when the partner reaches the age of 60. The units are thus redeemed at a rate of 20% per year over five years. At the end of the five years, the partner ceases to be active in the partnership.
A partner turned 60 and the adjusted cost base (ACB) of the partner’s units in the partnership was negative by $350,000. The redemption value of all of the units was $1,000,000. The individual redeemed 20% of the units for $200,000.
Subsection 40(3)(a) generates a capital gain when the ACB of a property becomes negative. That rule does not apply to partnerships. However, when an interest in a partnership is disposed of, the negative ACB will be taxed as a capital gain.
When 20% of the units in the partnership are redeemed, three different tax treatments can be argued:
- A capital gain of $200,000 on the basis that the partner has not disposed of the partner’s interest in the partnership since 80% of the units are still owned;
- A gain of $270,000, being the redemption amount plus 20% of the negative ACB on the basis that the partner disposed of units to which 20% of the negative ACB should be attached;
- A gain of $550,000, consisting of the redemption amount and the full negative ACB on the basis that the member disposed of an interest in a partnership, which triggers the full gain from the negative ACB.
Question to the CRA
What is the proper tax treatment of the redemption of 20% of the partner's units?
CRA Response
We are of the view that all the units that a partner holds in a partnership are one and the same property, that is, the partner's interest in the partnership. Therefore, when a partner has 20% of his or her units redeemed by the partnership, there is a partial disposition of the partner’s partnership interest.
In order to calculate the gain or loss arising from that partial disposition, reference must be made in particular to subsection 43(1) to determine the ACB of the part of the interest that is disposed of at the time of redemption.
Paragraph (d) of the definition of "adjusted cost base" in section 54 provides that in no case shall the ACB to a taxpayer of any property at any time be less than nil.
For the purposes of subsection 43(1), the ACB of the portion of the interest disposed of would therefore be nil. Consequently, the amount of the gain calculated under subsection 40(1) would be $200,000.
In addition to the gain that must be included in the partner's income under subsection 40(1), it is also necessary to include an amount calculated in accordance with subsection 100(2) since, in the situation before us and immediately before the redemption, the total of the amounts deductible under subsection 53(2) in computing the ACB of the interest exceeds the total of the cost and the amounts that must be added to the ACB of the interest at that time. Since the partner has disposed of 20% of the partner’s units in the partnership, the CRA is of the view that $70,000 - or 20% of the "negative" ACB immediately before the redemption - must be added in computing the partner's gain from the partial disposition of his interest in the partnership. Thus, the partner will be required to include a gain of $270,000 in the year of redemption.
Pierre-Luc Meunier
(514) 956-7086
October 8, 2010
2010-037346