Quirk in Definition of FA for Partnership Interest Gives Rise to FAPI

Consider the situation of a Canadian-resident taxpayer that effectively owns 10 percent or more of a foreign partnership engaged exclusively in an active business. In a technical interpretation (2014-0546581E5, November 5, 2014), the CRA has said that the sale of the foreign partnership may give rise to FAPI, depending on how the ownership interest is structured. This outcome appears to be contrary to the government’s policy intent and arises from a quirk in the calculation of the 10 percent factor in the definition of “foreign affiliate” (FA) in subsection 95(1).

In the structure addressed in the TI (illustrated in the accompanying figure), Mr. A and Mr. B are unrelated. Forco is an FA of a Canadian corporation (Canco 3) and a partner of a limited partnership (LP), which is held 10 percent by Forco and 5 percent by Canco 4, a sister corporation of Canco 3. Under paragraphs (d) and (e) of the definition of “excluded property” in subsection 95(1), the LP is deemed to be a non-resident corporation having 100 shares of capital stock. Forco owns 10 percent of LP and Canco 3 owns 50 percent of Forco, so Canco 3’s equity percentage in LP is 5 percent (10% × 50%). Therefore, when one is determining whether LP is an FA of Canco 3, the requirement that the equity percentage be at least 1 percent is satisfied (paragraph (a) of the definition of “foreign affiliate” in subsection 95(1)).

The problem arises with paragraph (b) of the definition. According to the CRA, Forco is the only partner of LP that is deemed to own LP’s hypothetical shares for the purposes of this paragraph of the definition. Canco 4’s interest in the LP cannot be taken into account, presumably because the deeming rule referred to above applies only to a foreign affiliate that has an interest in a partnership, and this is not the case for Canco 4. The resulting equity percentage of 5 percent is below the 10 percent threshold. As a result, the CRA concluded in the TI that LP is not considered an FA of Canco 3.

The second question is whether the partnership interest can be considered excluded property (as defined in subsection 95(1)) of an FA of a taxpayer where Forco is the FA and Canco 3 is the taxpayer. Paragraph (b) of the excluded-property definition refers to property that is a share of the capital stock of another FA of the taxpayer. As shown above, the partnership is not an FA of Canco 3, and thus cannot meet the definition. As a result, any capital gain from Forco’s disposition of its partnership interest (or from a disposition of assets by the LP) will be included in Forco’s FAPI and therefore in Canco 3’s income. (The CRA’s conclusion is consistent with its comments in the endnote to TI 2006-0168571E5, September 1, 2009, in which it was asked whether a partnership interest was excluded property in a different fact pattern.)

The CRA’s strict literal reading of the Act appears to be highly restrictive from a purely economic perspective. Canco 3 and Canco 4 (as a related group) together own, directly and indirectly, 10 percent of LP. If LP were a corporation instead of a partnership, it would be an FA of Canco 3, and the issue of FAPI would not arise. Finance could not have intended such a narrow application of the excluded-property deeming provision, especially in light of its legislative modifications relating to partnerships in a cross-border context.

The specific problem addressed in the TI could have been avoided if Mr. B had not set up Canco 4 and instead had flowed his entire 10 percent interest in LP through Canco 3. Still, tax rules should not create traps for the unwary.

Raphael Barchichat
PSB Boisjoli LLP, Montreal

Canadian Tax Focus
Volume 5, Number 3, August 2015
©2015, Canadian Tax Foundation