Holding a Foreign Affiliate Through a Partnership

Canadian-resident corporations that hold an interest in a foreign affiliate through a partnership may not benefit fully from the favourable foreign affiliate regime if the dividend income in the partnership agreement is not allocated according to the FMV of the different partnership interests. This may occur, for example, when there are different classes of partnership units with different rights (for example, one partner might have the fixed partnership units from a partnership freeze while another partner might have the partnership units that would represent the growth in value of the partnership). Consideration should be given to drafting the partnership agreement in such a way as to avoid this difference between the two methods of allocation.

For the purposes of certain provisions of the Act, including section 113, subsection 93.1(1) deems shares of a non-resident corporation owned by a partnership to be owned by the members of the partnership; subsection 93.1(2) deems the ownership to be on a pro rata basis according to the FMV of the members' interests.

In the absence of subsection 93.1(1), a Canadian-resident corporation would not be able to claim a deduction under section 113 for dividends received because section 113 refers to dividends received on the shares owned by the corporation. Under partnership law, corporate partners have an undivided interest in the partnership; however, they cannot claim outright ownership of the partnership property. As a result, a partnership includes in its income any dividends received, and it allocates such income to its members, who would otherwise not be able to claim a section 113 deduction. Subsection 93.1(1) offers relief, but the relief may be partial.

When a foreign affiliate pays a dividend to a partnership, the dividend is included in the income of the Canadian-resident corporate partner pursuant to subsection 96(1). The allocation of the dividend income is generally based on the income allocation provision of the partnership agreement. To the extent that there is sufficient surplus, a deduction under section 113 should be available to the Canadian-resident corporate partner. However, subsection 93.1(2) deems each member to have received a dividend equal to its pro rata FMV of the members' interests in the partnership. Moreover, pursuant to subsection 93.1(2), the maximum amount deductible under section 113 is limited to the Canadian-resident corporate partner's share of the dividend determined in accordance with the partnership agreement.

Problems can arise if the amount of the dividend allocated to the Canadian-resident corporate partner under the partnership agreement is greater than that partner's pro rata share of the dividend based on the FMV of its interest in the partnership relative to all interests in the partnership.

Assume, for example, that a Canadian-resident corporation (Canco) is a member of a partnership. The partnership owns all of the outstanding shares of a foreign corporation (Forco). Forco is a foreign affiliate of Canco as a result of the deeming rule in subsection 93.1(1). The FMV of Canco's interest in the partnership is equal to 50 percent of the FMV of all of the members' interests in the partnership. According to the partnership agreement, Canco's income allocation is 70 percent. Forco has exempt surplus of $100. Forco pays a dividend of $100 to the partnership. On the basis of the partnership agreement, 70 percent of this income is allocated to Canco.

In the situation described above, Canco includes $70 of dividends in its income pursuant to subsection 90(1). However, subsection 93.1(2) deems each partner to have received a dividend equal to its proportionate FMV of the members' interests in the partnership. Accordingly, the section 113 deduction available to Canco is limited to $50, resulting in a net income inclusion of $20 that is subject to tax in Canada.

Note that this issue is specifically related to the ownership of the foreign affiliate through a partnership; if Canco owned the foreign affiliate directly, the problem would not arise.

Karthika Ariyakumaran and Michael Spinelli
KPMG LLP, Toronto

Canadian Tax Focus
Volume 8, Number 1, February 2018
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