Taxation (Limited Partnerships) Act 2008
2008 legislation introduces new tax rules for limited partnerships and updates existing income tax rules relating to general partnerships.
Sections CB 27B, CB 35, CU 3 to CU 10, CU 11(2), CU 17, CU 19(6)(c), CW 55B, CX 62, DV 20, DO 11B, DU 1 to DU 7, DU 8(2), EW 58(2), EX 13, EZ 37(10), GB29(2)(b), GB 50, HD 20, HD 20B, subpart HG, HR 1, HZ 3, HZ 4, RE 30, YA1, YB 16(1B), YB 17(1B), YD 4(17B) of the Income Tax Act 2007; sections 22(4)(c) and 42 of the Tax Administration Act 1994; section 2(1) of the Goods and Services Tax Act 1985
Recently enacted legislation introduced new tax rules for limited partnerships and updated and clarified the existing income tax rules relating to general partnerships.
The changes were part of the Limited Partnerships Bill, introduced in August 2007, which also introduced new regulatory rules for limited partnerships that were intended to make it easier for New Zealand firms to have access to investment capital. That was achieved through the introduction of a new limited partnership vehicle that allows partners to participate in a partnership while limiting their liability in particular circumstances.
The resulting Limited Partnerships Act 2008 and Taxation (Limited Partnerships) Act 2008 received Royal assent on 13 March 2008. The latter amended the Income Tax Act 2007, the Tax Administration Act 1994 and the Goods and Services Tax Act 1985.
This article describes the resulting tax changes. Unless otherwise stated, section references are to the Income Tax Act 2007, where the main changes occurred.
The primary objective of the new limited partnerships rules is to facilitate sustainable growth in New Zealand's investment capital sectors such as venture capital. Given that New Zealand is disadvantaged by size and distance, it was particularly important for New Zealand to adopt a limited partnership structure that was consistent with international norms and provided a legal and tax structure that is recognised and accepted by investors.
New Zealand previously had a statutory form of limited partnership called the "special partnership", as described in Part 2 of the Partnership Act 1908. However, because the legislation was outdated, it did not have all the features preferred by foreign venture capital investors, and the local venture capital industry had been unable to make use of the existing special partnership rules. These rules have now been replaced by the Limited Partnerships Act 2008.
The associated tax changes are contained in the Taxation (Limited Partnerships) Act 2008.
- A new definition of "partnership" clarifies which partnership arrangements are covered by the new rules.
- Income, expenses, tax credits, rebates, gains and losses are allowed to flow through to individual partners. These items will generally be allocated to the partners in proportion to each partner's share in the partnership's income. Partners are also able to deduct partnership expenditure incurred by the partnership before they became a member, subject to the other deductibility tests in the Act.
- Transactions between partners within partnerships that are not at market value and that undermine the partnership income tax rules need to be at market value for tax purposes, a requirement designed to protect the tax base.
- Partners are required to account for tax on exiting the partnership only if the amount of the disposal proceeds derived from the partnership interest exceeds the total net tax book value of their share of partnership property by more than $50,000. However, if this threshold is exceeded, exiting partners will not have to account for tax on things such as trading stock in certain circumstances. When exiting partners account for tax on their share, incoming partners and the partnership must take on a cost basis in the partnership's assets and liabilities that is equal to the deemed disposal under the disposal provisions. When exiting partners account for tax on livestock, incoming partners may deduct the value of the adjustment on a straight-line basis over five years. Partners in a partnership of five or fewer partners may elect to be treated as owning an undivided interest in the property and income of the partnership instead of following the partnership interest disposal rules.
- The new rules clarify when dissolution of a partnership occurs for tax purposes and the tax consequences of dissolution.
- Tax loss limitation rules for limited partners ensure that the losses claimed reflect the level of their economic loss. Limited partners' excess tax losses are also available for carry-forward to future income years. Furthermore, an anti-avoidance rule has been introduced to prevent artificially high basis around the year-end being used to increase any loss flow-through.
- General partners of a limited partnership are treated as an agent of an absentee limited partner.
- A simple transition from a special partnership to a limited partnership will not generally result in the triggering of income tax provisions to the partners. Special partnerships that still exist are not required to comply with the loss limitation rules.
- Two options are available for the calculation of a limited partner's opening basis amount for existing partnership interests.
- The rules also clarify how the income tax source rules apply to partnership income.
- The record-keeping and filing obligations of partnerships have been clarified.
For general partnerships, the amendments apply to income years beginning on or after 1 April 2008. For limited partnerships, the new rules apply to limited partners from 1 April 2008.
Definition of partnership
A new definition of "partnership" in section YA 1 of the Income Tax Act 2007 specifies the partnership arrangements that are covered by the new rules. The Act previously contained no general definition of "partnership". Under the new definition a partnership is a group of two or more persons who have, between themselves, the relationship described in section 4(1) of the Partnership Act 1908. The Income Tax Act 2007 definition of "partnership" includes a joint venture and co-owners of property if the joint venturers or co-owners all choose to be treated as a partnership for income tax purposes. A limited partnership is also included in the new partnership definition.
A new definition of "limited partnership" has been inserted into section YA 1 of the Income Tax Act 2007. A limited partnership is one that is registered under the Limited Partnerships Act 2008. It must have at least one general partner and one limited partner. A general partner is responsible for the management of the partnership, while a limited partner is not responsible for management.
"Limited partnership" includes an "overseas limited partnership", as defined in section 4 of the Limited Partnerships Act 2008. Under that definition, it is a partnership formed or incorporated outside New Zealand that has at least one general partner who is liable for the debts and liabilities of the partnership and at least one limited partner who is not. Such a partnership does not have separate legal entity status.
The new definition of limited partnership excludes a "listed limited partnership", which is an entity or group of persons that is listed on a recognised exchange and is either a limited partnership registered under the Limited Partnerships Act 2008 or an overseas limited partnership.
The limited partnership definition also excludes a "foreign corporate limited partnership", which is an overseas limited partnership that is treated as a separate legal entity under the laws (other than taxation laws) in the jurisdiction where it was established.
The liability of general and limited partners is set out in Part 2 of the Limited Partnerships Act 2008. The liability of limited partners is limited by the extent to which they contribute to the management of the partnership. Limited partners' activities are limited to "safe harbour activities" and must not extend to the day-to-day management of the partnership.
A limited partnership is a separate legal entity under the Limited Partnerships Act 2008. However, under the Income Tax Act 2007 a limited partnership is not treated as a "company" and instead is treated as a partnership. As a result, income and expenses will flow through the limited partnership to the partners. Therefore the limited partnership itself will not be taxed; instead, partners will be taxed individually.
Transparency of partnerships
Section HG 2 codifies the principle that partnerships are transparent for income tax purposes. For the purposes of calculating partners' obligations and liabilities, they are treated as carrying on activities and having the status, intention and purpose of the partnership. Partnerships are treated as not carrying on these activities or having such an intention or purpose. This does not necessarily mean that the activities, status or intention of a partnership are attributed to partners in relation to their non-partnership activities. For example, a partner of a land-dealing partnership is not treated as having the status or intention of the partnership in relation to land that he or she owns in a capacity other than that of a partner.
Partners are also treated as holding property in proportion to their partnership share, being parties to an arrangement, and doing or being entitled to a thing, through their capacity as partner. Partners will be treated as doing, having, or being party to these things, and partnerships will not. In the absence of a partnership agreement, these items will be apportioned to partners under the Partnership Act 1908 or whichever law determines their right to a share in the partnership income.
There are limited situations, however, where partnerships are not treated as being transparent for tax purposes. This is recognised in section HG 2(1), which outlines the principle that partnerships are transparent "...unless the context requires otherwise". An example of a situation where it is clear from the statutory context that a partnership should not be viewed as transparent is in relation to resident withholding tax (RWT) exemption certificates. Section RE 30 of the Income Tax Act 2007 and section 32J of the Tax Administration Act 1994 provide that it is the partnership rather than the partners that holds an RWT exemption certificate.
Amendments have been made to income and deduction provisions, and in particular to sections CB 35, CW 55B, CX 62 and DV 20, that reflect the changes made by section HG 2.
Flow-through of income, expenses and other items
Section HG 2(2) provides that income, tax credits, rebates, gains, expenditure or loss of the partnership will be allocated in proportion to each partner's share in the partnership's income or, in the absence of a partnership agreement, in accordance with the relevant law.
The proportionate approach prevents streaming of these items to specific partners, by requiring them to be allocated to the partners in the same proportion as their respective shares in the partnership's income. It will also provide certainty in the allocation of these items for income tax purposes, and ensure that they cannot be streamed to take advantage of the different tax circumstances of the partners.
The proportionate approach does not, however, prevent a partner from having different proportions of shares in different types of partnership property. This is clear from the definition of "partnership share" in section YA 1, which defines "partnership share" as the partner's share in each different type of partnership property. This allows, for example, a partner's share in the income to be different from the partner's share in the assets for income tax purposes.
Under section HG 2(3) expenditure apportioned to new partners who were not partners when the expenditure was originally incurred will generally be deductible, subject to the other tests of deductibility in the Income Tax Act. This marks a departure from the previous law as new partners were previously not entitled to claim expenditure incurred through the original partnership because they did not generally meet the "incurred test". The deduction will be allocated to either the exiting or the incoming partner. It will not be available to both.
Transactions between partners and partnerships
New section GB 50 provides that transactions between partners under an arrangement will be treated as being at market value for income tax purposes if a purpose or effect of the arrangement is to defeat the intent and application of the new partnership rules in subpart HG. This is designed to protect the tax base.
Transactions that do not occur at market value, such as goods provided at a discount, are likely to have an impact on limited partners' partnership basis, with excess value given to a partnership being treated as a capital contribution, and excess value received from a partnership being treated as a distribution.
Entry and exit of partners and changes to partnership interest
Under the transparent approach for partnerships provided in section HG 2, partners are treated as holding the partnership property directly, carrying on the activities of the partnership and having the status and intention of the partnership. Therefore when partners exit the partnership by disposing of their partnership interest they would, without specific provision otherwise, be treated as disposing of their share of the underlying partnership property and bearing any tax consequences associated with the disposal. This could result in significant compliance costs for partners and partnerships.
Therefore sections HG 5 to HG 9 remove the requirement for the exiting partner to account for tax when the tax adjustment that would otherwise be required is below certain thresholds. When these provisions apply, the new partner (the "entering partner") is treated as acquiring the partnership interests for the same cost that the exiting partner had acquired them. In other words, the entering partner receives the same cost basis as the exiting partner - thereby ensuring that the tax consequences associated with the exit are delayed rather than extinguished. In these situations, therefore, the entering partner can effectively bear the tax obligations of the exiting partner and may adjust the purchase price of the partnership interest accordingly.
Partners in "small partnerships" (defined in section YA 1 as those partnerships with five or fewer partners that are not limited partnerships) can elect out of sections HG 5 to HG 9 by furnishing a return of income that ignores these sections. In this situation the partners will be treated as owning an undivided interest in the property and income of the partnership.
$50,000 threshold - section HG 5
Under section HG 5 a partner is required to account for tax on exiting the partnership only if the amount of the disposal proceeds derived from the partnership interest exceeds the total net tax book value of the partner's share of the partnership property (less any liabilities under generally accepted accounting practice) by more than $50,000. When interests in the same partnership have been sold within a 12-month period, all sales are taken into account for the purposes of the threshold. The following simple example illustrates the operation of section HG 5.
In May 2009 Paul and John establish a two-person partnership. The business of the partnership is to buy shares in New Zealand-resident listed companies with the purpose and intention of making a profit on resale. They each contribute $50,000 to the partnership and, therefore, each have a partnership share of 50 percent. The partnership uses the $100,000 to purchase 10,000 shares in A Co for $10 per share. The partnership and the partners have a standard balance date.
In March 2010 the market value of the partnership's shares in A Co has risen to $150,000 ($15 per share). In the same month John sells his entire 50 percent partnership interest to Janet for $67,500. (Even though the shares have a market value of $75,000 Janet negotiates a discounted purchase price to compensate for additional tax liabilities that she may face.).
Application of new tax rules for the 2009-10 income year
Section HG 2(1)(a) treats John as carrying on the share trading business of the partnership. Section HG 2(1)(b) treats him as holding 50 percent of the A Co shares directly. Section HG 2(1)(d) treats him as doing a thing that the partnership does. John is therefore treated as purchasing 50 percent of the underlying shares in A Co and disposing of these shares when he sells his entire partnership interest to Janet in March 2010. Therefore, without section HG 5, the profit of $17,500 ($67,500 minus $50,000) would be taxable to John.
The partners and the partnership decide not to elect out of section HG 5. Section HG 5 applies in this case as the taxable profit for which John would otherwise be liable is less than $50,000. (That is, under section HG 5(1) the "disposal payment" ($67,500) plus any "previous payments" ($0) minus the "gross tax value" ($50,000) minus "liabilities' ($0) minus $50,000 is less than zero.) This means that John is not taxable on the $67,500 disposal payment (section HG 5(3)) and does not have a deduction for the $50,000 spent on the shares in A Co (section HG 5(4)).
Section HG 5(6) treats Janet (the entering partner) as having acquired the original partnership interests. In other words, for the purposes of calculating future tax liabilities, Janet's cost basis for the shares in A Co is $50,000.
Sections HG 6 - HG 9
Even if the $50,000 threshold in section HG 5 is exceeded, however, an exiting partner does not have to account for tax, in certain circumstances, on:
- Trading stock - section HG 6
Exiting partners do not have to perform a revenue account adjustment for trading stock if the total annual turnover of the partnership is $3 million or less.
- Depreciable tangible property - section HG 7
Exiting partners do not have to account for depreciation recovery or loss on their share of any depreciable tangible asset of the partnership if the historical cost of the asset is $200,000 or less.
- Financial arrangements - section HG 8
Exiting partners are not required to perform a base price adjustment for their interest in a financial arrangement if:
- the partnership is not itself in the business of deriving income from financial arrangements; and
- the financial arrangement has been entered into as a necessary and incidental purpose of the business.
For example, exiting partners are not generally required to perform a base price adjustment in respect of their interest in a loan that provides capital for a partnership's business.
- Certain financial arrangements and excepted financial arrangements - section HG 8
Exiting partners do not have to account for tax on financial arrangements and excepted financial arrangements described in section EW 5(10). These are interest-free loans made in New Zealand currency that are repayable on demand.
- Short-term sale and purchase agreements - section HG 9br> Section HG 9 applies when exiting partners dispose of some or all of their partnership interests in a short-term sale and purchase agreement. The consideration that the exiting partner receives is excluded income. In addition, both the entering and exiting partners are denied any deduction for this. In the exiting partner's case, this is because for income tax liability purposes the entering partner is treated as having originally acquired the property or services contained in the agreement.
Livestock - sections HG 10, CB 27B, DO 11B
Section HG 10 applies when a partner exits the partnership and the partnership property consists of livestock that is not valued using the herd scheme or one of the cost price, replacement price or market value methods described in section EC 25. In these circumstances the entering partner is treated as if they had originally purchased and held the livestock - not the exiting partner. This is designed to reduce compliance costs for partnerships as the partnership will not be required to maintain different cost bases for different partners.
If the exiting partner has accounted for tax on the livestock, the entering partner can choose to deduct the amount of that adjustment on a straight-line basis over a five-year period under section DO 11B. Similarly, if an exiting partner has a loss on disposal for livestock, the incoming partner must account for income on a straight-line basis over a five-year period under section CB 27B.
However, the partnership and the partners can opt out of the five-year spreading method under section HG 10(3) by furnishing a joint return of income that ignores the section.
When an exiting partner accounts for tax on exit
When exiting partners account for tax in respect of their share of the partnership assets and liabilities, the partnership and the incoming partner must take on a cost base in the partnership's assets and liabilities. The cost base must be equal to the amount the exiting partner was deemed to have disposed of them for under the disposal provisions.
In these situations incoming partners will generally acquire their partnership interest at market value. This means that, generally, they will take on a market value cost base in partnership assets and liabilities. An exception is livestock, which is discussed above.
Introduction of a new partner
The introduction of a new partner into a partnership does not trigger a tax event for the existing partners. This is because the addition of a new partner would not result in a "disposal" of partnership property for an existing partner under section YA 1.
Dissolution of a partnership
The new tax rules clarify when dissolution of a partnership will occur for tax purposes, and the tax consequences of dissolution. Previously, the legislation was silent as to the tax consequences of partnership dissolution. New section HG 4 deems the partnership to have disposed of all its assets at market value for tax purposes on dissolution. A partnership is not automatically treated as dissolving for tax purposes when there is a change in partners or a smaller change in partnership interests, but there is a deemed sale and reacquisition by all partners at market value when the partnership finally dissolves through the agreement of partners, or through operation of law by which fewer than two parties remain, or by an order of the court.
The Minister of Revenue has announced a proposal that would provide an exception to the general rule that triggers a tax event for partners upon dissolution of a partnership. According to the announcement, the exception would apply to dissolutions of two-person partnerships where the partners are married, or in a relationship in the nature of marriage, and the dissolution is caused by the death of one of the partners. When this occurs the surviving spouse will often inherit the deceased spouse's partnership share under the deceased spouse's will. Under the current law any tax consequences associated with the inherited share are delayed until the surviving spouse sells the assets. In these circumstances it is proposed to delay the triggering of a tax event in respect of the surviving spouse's original partnership share until the assets are actually sold. This measure is designed to reduce compliance costs for surviving spouses. The announcement states that the measure will apply from the start of the 2008-09 income year.
Limitation of limited partner's tax losses
New section HG 11 ensures that limited partners' tax losses are restricted if the amount of the loss exceeds the tax book value of their investment (the partner's basis). This is to ensure that limited partners can offset tax losses only to the extent they reflect their economic losses. This provision applies only to limited partners because general partners have unlimited liability and therefore full exposure to the risk of loss.
A limited partner's adjusted investment in a partnership is referred to as the "partner's basis". In calculating their basis, limited partners will take into account the sum of their:
- investment contributions
- share of the partnership debt guaranteed (or indemnities provided) by the partner
- share of the net limited partnership income previously recognised
- share of the capital gains previously realised
- any previous equity injections
- share of the partnership debt guarantees (or indemnities) retired or extinguished by the partner
- share of the net limited partnership loss previously deducted
- share of the capital losses previously realised
- any previous distributions.
If their basis is reduced to nil and they are denied a deduction for a tax loss for an income year under section HG 11, the deduction is carried forward to the next income year under section HG 12. The deduction becomes available when additional basis becomes available, such as when a partner contributes more capital to the partnership (putting more capital at risk) or the partnership earns income.
The following simple example explains how these rules work.
On 1 April 2009 Limited Partnership X is established. Limited Partnership X has two partners - Eve and Sam - who each make an investment of $10,000. They share equally in the net income and loss of the partnership.
Partnership X borrows $1 million from the bank at an annual interest rate of 10%. The annual interest cost of $100,000 is deductible under the Income Tax Act 2007. On 1 June 2009 the partners each receive a distribution from the partnership of $5,000. The partnership derives $20,000 of gross income for the 2009-10 income year.
Application of tax rules to Eve for the 2009-10 income year
Eve has a partnership share in the income of Limited Partnership X of 50 percent. Therefore, under section HG 2(2), she has gross income of $10,000 (50% of $20,000) and an allowable deduction of $50,000 (50% of $100,000) from the partnership.
However, section HG 11(2) denies her a deduction to the extent that the amount exceeds her basis in the partnership. For the 2009-10 income year she has basis in the partnership of $15,000 - calculated under section HG 11(3) as follows:
| || |
| ||$5,000 |
| ||$10,000 |
| ||$0 |
This means that the deduction she is allowed for the 2009-10 income year from her investment in Limited Partnership X is $15,000. Under section HG 12(2) she carries forward the $35,000 deduction she is denied to the next income year. She will need to apply section HG 11 again in the next income year to determine how much of the deduction is allowed in that year.
To prevent the artificial creation of a high basis around the end of the year when loss flow-through is taken into account, a limited partner's basis is reduced by the amount the basis is increased if:
- the limited partner's basis is increased within 60 days before the end of the income year, and
- the limited partner's basis is subsequently reduced within 60 days after the end of the income year.
General partner liable if limited partner an absentee
New section HD 20B ensures that the general partner of a limited partnership is treated as an agent of an absentee limited partner for income derived from a partnership business carried on in New Zealand. It is anticipated that limited partnerships will be widely held and similar to a company; therefore it would be impractical to impose this liability on all the partners. General partners in a limited partnership are usually responsible for management of the limited partnership and are also liable for the debts and obligations of the partnership. General partners are therefore treated as agents of an absentee limited partner for income derived from a partnership business carried on in New Zealand.
Part 2 of the Partnership Act 1908, which relates to special partnerships, has been replaced by the Limited Partnerships Act 2008. Under section HZ 3 of the Income Tax Act 2007 special partnerships will continue to exist until their expiry. Partners of special partnerships are not required to comply with the loss limitation rules for this remaining period.
Under the previous rules, the cessation of a special partnership and the creation of a limited partnership would generally have crystallised a tax event. However, under the new rules, a simple transition from a special partnership to a limited partnership will not generally have income tax consequences for the partners if the business and ownership of the partnership remains the same.
New Zealand-resident partners of special partnerships that make the transition into the new limited partnership rules can determine their initial basis by either:
- the market value of their interest in the limited partnership, or
- calculating their basis as if the rules were in effect the entire time the partner has held the partnership interest.
Associated persons rules
Section YB 16 treats a partnership and a partner in the partnership as associated persons. The section has been amended to provide an exception in the case of a limited partner. Limited partners and their respective limited partnership will be associated persons only if the limited partners have a partnership share of 25 percent or more in the limited partnership.
Section YB 17 also treats a partnership and a person associated with a partner as associated persons. The section has been similarly amended so that a limited partnership and a person associated with a limited partner will be associated persons only if the limited partner has a partnership share of 25 percent or more.
Section YD 4 has been amended to provide that income is treated as being sourced in New Zealand if, treating all the partners of a New Zealand partnership as resident in New Zealand, the income is sourced in New Zealand under a provision in that section. A "New Zealand partnership" is defined in section YA 1 as a partnership that is a limited partnership registered under the Limited Partnerships Act 2008, or has 50percent or more of its capital held by New Zealand residents, or has its centre of management in New Zealand.
A number of provisions that provided that partnerships were transparent for specific income tax purposes have been repealed because the general transparent approach in new section HG 2 made them redundant. The repealed provisions are sections CU11(2), CU 19(6)(c), DU 8(2), EW 58(2), EX 13 and EZ 37(10). Section HR 1, which related to partnerships and joint ventures, has been repealed as a consequence of the enactment of the new partnership rules in subpart HG. The parts of former section HR 1 that related to persons other than partners who derive income jointly or have deductions jointly have been relocated to new section HG 1.
Record-keeping and filing requirements
Section 22 of the Tax Administration Act 1994 has been amended to clarify that it is the partnership, rather than each partner in the partnership, that must maintain records, in accordance with the usual practice.
Tax legislation often refers to a "person's" obligation to fulfil record-keeping requirements. A partnership is a "person" within the meaning of the Interpretation Act 1999 (being an unincorporated body of persons), as is a partner. It can be inferred from this that all partners, as well as the partnership, must maintain separate (yet identical) records. In practice, the partnership typically keeps one set of records relating to all the partners and all the firm's activities. The new legislation brings the law into alignment with current practice.
Section 42 of the Tax Administration Act 1994 has been amended to clarify the return filing obligations of partnerships and partners.
Goods and Services Act 1985
The interpretation section of the Goods and Services Act 1985 has been amended to clarify that a limited partnership will be treated as a company for GST purposes.