Taxation of partnerships

By Graham Murray, Senior Associate | Friday 27 November 2009

First published in Taxation Today, December 2009 issue.

The Taxation (Limited Partnerships) Act 2008 significantly reformed the rules governing the income tax treatment of partnerships and partners, with effect from 1 April 2008. The enactment of these new tax rules coincided the with passage of the Limited Partnerships Act 2008 (the LPA 2008), which introduced a new "limited partnership" regime aimed at encouraging venture capital investment in New Zealand.

The new partnerships tax rules are mainly contained in Subpart HG of the Income Tax Act 2007 (ITA 2007). Those rules apply to ordinary partnerships, limited partnerships (with some exceptions), and joint venturers or certain co-owners of property that elect to be treated as a partnership for tax purposes.

This article describes the types of co-investment structures to which the partnership tax rules apply and the key rules relating to the taxation of income derived through those structures. The second article in this series will address the taxation of the acquisition and disposal of partnership interests (including the rules relating to the dissolution of a partnership). The third and final article will outline the loss limitation rules for investors in the limited partnership, the taxation treatment of transactions between partners and some issues relating to non-resident partners.

Scope of the partnership rules

The partnership tax rules in Subpart HG of the ITA 2007 apply to vehicles that meet the definition of "partnership" in s YA 1 ITA 2007. In broad terms, that definition incorporates:

• Ordinary partnerships (ie those having the relationship described in s 4(1) Partnership Act 1908);

• Limited partnerships (with limited exceptions); and

• Joint venturers or certain co-owners of property that elect to be treated as a partnership for the purposes of the ITA 2007.

Each type of "partnership" to which the rules apply is described below.

Ordinary partnerships

Section 4(1) Partnership Act 1908 describes an ordinary partnership as a group of persons carrying on business in common with a view to profit. Separating the relevant components of this definition:

• There must be a business;

• The business must be carried on by two or more persons in common;

• The business must be carried on with a view of profit.

An ordinary partnership is formed by agreement between the partners and is therefore a creature of contract. However, it is not essential that there be a written partnership agreement (although this is usually the case).

Under general law, a share in an ordinary partnership is a chose in action, being a proportionate interest in the future profits of the partnership business and in any surplus of net assets of the partnership on winding up. While each partner does not have title to specific partnership assets, each partner has a beneficial interest in the entirety of the partnership assets and in each particular asset of the partnership.

Unlike a company or a limited partnership (which are addressed below), an ordinary partnership is not a legal entity separate from its partners. Partners in a general partnership have unlimited liability for the partnership's liabilities.

Limited partnerships

"Limited partnerships" are defined in s YA 1 ITA 2007 to include:

• "Overseas limited partnerships" (as defined in s 4 LPA 2008); and

• Limited partnerships registered under the LPA 2008.

An "overseas limited partnership" is, broadly, a partnership formed overseas that has at least one partner who is liable for all partnership debts and liabilities of the partnership and at least one partner who has limited liability for partnership debts and liabilities. An important qualification is that an overseas limited partnership will be deemed to be a "company" for tax purposes if it is treated as an entity separate from its partners in the foreign jurisdiction or if it is listed on a recognised exchange.

A limited partnership registered under the LPA 2008 is likely to be the main type of limited partnership that is subject to Subpart HG of the ITA 2007 (although a limited partnership will be a deemed company if it is listed on a recognised exchange).

The LPA 2008 was enacted with effect from 2 May 2008. Its main purpose was to establish an investment entity that was both flexible and internationally recognised in order to encourage venture capital investment in New Zealand. The LPA 2008 also repealed the provisions of the Partnerships Act 1908 relating to "special partnerships" (which also offered some limitation of liability), recognising that these outdated and infrequently used vehicles would be superseded by limited partnerships.

Legal status of a limited partnership

A limited partnership registered under the LPA 2008 shares the same fundamental legal features as an ordinary limited liability company. That is, the limited partnership is created upon registration (under the LPA 2008) and has a legal status that is separate from its owners (ie its partners).

Each limited partnership must have a written partnership agreement which governs the affairs of the limited partnership. The agreement must comply with certain minimum content requirements in the LPA 2008. A limited partnership is therefore a creature of both statute and contract.

Much like a company, a limited partnership can carry on any business (including a banking or insurance business) and enter into any transaction (subject to limited restrictions in the LPA 2008). A limited partnership may have an unlimited legal life, unlike the old special partnerships which had a maximum life of 7 years (subject to renewal).

Two types of partner

The LPA 2008 requires that a limited partnership has at least one general partner and one limited partner. However, there is no upper limit on the number of general and limited partners that a limited partnership may have. The absence of a general partner or a limited partner for a period of 10 or more working days will result in the termination of the limited partnership.

Both general and limited partners may contribute capital to the partnership and therefore have a "partnership interest", although a general partners will not usually be expected to contribute capital to the partnership given that they have unlimited liability for partnership debts (this is addressed below).

The same person or entity cannot be both a limited partner and a general partner in the same limited partnership. However, there is no requirement that a general partner and the limited partner be non-associated. Therefore, a limited partnership may be validly constituted of a general partner and a limited partner that are "sister companies", for example. A common limited partnership structure that is emerging involves the use of a new company to act as the general partner, the shares in which are owned by the limited partners in proportion to their interest in the limited partnership.

Role of the general partner

General partners are responsible for the management of the partnership. General partners are jointly and severally liable, with each other general partner and the limited partnership, for the debts and obligations, and "wrongs and omissions" of the limited partnership. The liability of a general partner extends only to debts, obligations, wrongs or omissions that arise while that person or entity was a general partner of the limited partnership. In addition, the liability of a general partner is "residual". This means that a general partner may only be liable for limited partnership debts to the extent that the assets of the limited partnership are insufficient to satisfy those debts.

Other key points to note in relation to the role of general partner:

• The names and addresses of general partners are included on a publicly searchable register;

• The general partner is the agent of the limited partnership; and

• The general partner has a range of statutory responsibilities, including "authorising" any limited partnership distributions and confirming that the limited partnership satisfies the "solvency test" provided for in the LPA 2008 in respect of any such distribution.

Role of the limited partner

Limited partners are generally passive "investors" in the limited partnership who are responsible for providing the assets or capital to the limited partnership. Limited partners are not permitted to participate in the management of the limited partnership, except for certain "safe harbour" management activities listed in the Schedule to the LPA 2008.

Much like a shareholder in a limited liability company, limited partners are only liable for limited partnership debts to the extent of their capital contribution. However, the benefit of limited liability is lost if the limited partner engages in non-safe harbour management activities.

A limited partner that engages in non-safe harbour management activities is potentially worse off than a general partner in respect of limited partnership debts. This is because a limited partner's liability is not "residual", meaning that creditors may seek to recover from the limited partner first before seeking to liquidate partnership assets.

Other key points to note in relation to the role of limited partner:

• The names and addresses of limited partners are not publicly available (those details are included on a register but that register is not publicly searchable). This could represent an advantage over an investment in a company;

• A limited partner is not an "agent" of the limited partnership or any of the partners and has no authority to bind the limited partnership; and

• A limited partner owes no fiduciary duties to the limited partnership or to any of their fellow partners.

Co-owners and joint venturers

As a general proposition, mere co-owners of property and joint venturers are not treated as "partnerships" for the purposes of the Partnership Act 1908.

However, the ITA 2007 allows such co-owners or joint ventures to elect to be treated as a "partnership" for income tax purposes. The election is only effective if all co-owners or joint venturers (as the case may be) choose to apply the partnership tax rules.

No election can be made where co-ownership arises as a result of two people being shareholders of the same company or settlors, trustees or beneficiaries of the same trust. This limitation preserves the operation of the tax rules for companies and their shareholders and the trust tax rules.

Transparency for tax purposes

A vehicle that satisfies the definition of "partnership" is treated as a "flow through" vehicle for income tax purposes. This principle is confirmed by s HG 2(1) ITA 2007. It is an important provision worthy of repeating in full:

For the purposes of a partner's liabilities and obligations under this Act in their capacity of a partners of a partnership, unless the context requires otherwise,-

• The partner is treated as carrying on an activity carried on by the partnership, and having a status, intention, and purpose of the partnership and the partnership is treated as not carrying on the activity or having the status, intention, or purpose:

• The partner is treated as holding property that a partnership holds, in proportion to the partner's partnership share, and the partnership is treated as not holding the property:

• The partner is treated as being party to an arrangement to which the partnership is a party, in proportion to the partner's partnership share, and the partnership is treated as not being party to the arrangement:

• The partner is treated as doing a thing and being entitled to a thing that the partnership does or is entitled to, in proportion to the partner's partnership share, and the partnership is treated as not doing the thing or being entitled to the thing.

Section HG 2(1) provides the foundation for the proposition that income derived and expenditure incurred through a partnership will be treated as derived or incurred (as the case may be) by each partner in accordance with their partnership share, and not by the partnership itself. That is, unlike a limited liability company, there is only one level of taxation imposed in respect of income derived by a person through a partnership.

This transparent tax treatment makes partnerships an attractive prospect for charities and other tax exempt entities. The structure allows these entities to derive income directly from a business activity or investment without that income suffering tax in the hands of the investment vehicle itself (which would ordinarily generate non-refundable imputation credits).

The tax transparency of a partnership also makes it an ideal structure for investments that are expected to generate losses. The expenditure generating partnership losses is treated as being incurred by the partners personally, with the consequence that those losses are available to partners to shelter income from other sources. By contrast, losses generated by a company from an investment cannot be passed on to investors unless the investor is a company that holds a 66% or greater interest in the company, or the company (and its shareholders) can elect into the LAQC regime.

In addition, the effect of s HG 2(1) is that capital gains realised by a partnership are treated as being realised by the partner in proportion to the partner's partnership share (and not by the partnership). Capital gains therefore flow through to partners, including non-resident partners, on a tax-free basis, as and when those gains are realised. By contrast, capital gains realised by a company cannot be distributed to shareholders in a tax-free manner until the company is liquidated and, in fact, cannot be distributed tax free at any time to non-resident corporate shareholders that are associated with the company. Furthermore, capital gains generated from related party transactions cannot be distributed tax-free on liquidation of a company, unless there is sufficient available subscribed capital to cover those gains.

The fact that partners of a partnership are treated as holding partnership property in proportion to their partnership share is also significant. Perhaps the main consequence is that a partner who disposes of their interest in a partnership will be treated as disposing of their share of each individual item of partnership property, potentially triggering taxable gains where that property is held on revenue account, or depreciation recovery income or loss where the property is depreciable property. The partnership rules include safe harbour provisions that are intended to relieve partners who dispose of their partnership interests from the tax consequences that would ordinarily flow from those disposals. These safe harbour rules will be addressed in a later article in this series.

While most of the concepts in s HG 2(1) are relatively uncontroversial, the proposition in s HG 2(1)(a), that partners are attributed the purpose or intention of the partnership, gives rise to practical difficulties. First, this principle rules out the possibility of individual partners having a different purpose or intention in respect of the same item of partnership property. The presence of a taxable purpose (eg a purpose of resale) at the partnership level will therefore taint all individual partners, irrespective of what purpose they may individually have in respect of that property. On the other hand, a non-taxable purpose held by a partnership will be attributed to a partner even though the partner may individually have a taxable purpose in respect of the property. In this regard, new partners who may otherwise have had a taxable purpose may seek out partnerships that have a pre-existing non-taxable purpose so that this non-taxable purpose can be attributed to them (thereby displacing their taxable purpose).

Second, and perhaps more fundamentally, the rules are silent on how one is to ascertain the purpose or intention of a partnership as a whole (and indeed assumes that it is always possible to do this). One view is that the purpose of the partnership is to be derived from the partners themselves, then attributed to the partnership and back to the partners themselves. Obviously, few issues would arise with this approach where each partner has a common purpose or intention, but what about where some partners hold one purpose but not others? Sensibly, one might attribute the purpose of the majority of partners to the partnership in these circumstances, but it is not clear whether this would be acceptable.

An alternative approach is that the purpose of the partnership must be ascertained objectively from the surrounding circumstances, treating the partnership as a hypothetical person that is distinct from its partners. There would be no recourse to the subjective purposes and intentions of the individual partners in that partnership, although these purposes may be relevant insofar as they flavoured the surrounding circumstances of the partnership. The most obvious difficultly with this approach is that it assumes that a partnership is capable of having a purpose that is distinct from the purposes of its partners.

The practical difficulties associated with ascertaining the purpose or intention of a partnership would be compounded where purposes change over time. At some point in time the partners and activities of a partnership may have changed so significantly that the partnership cannot sensibly be regarded as holding its original purpose or intention. It will be difficult to judge when changes in the constitution of the partnership will trigger the displacement of the partnership's original purpose.

Restrictions on streaming income

One of the traditional tax advantages of partnerships was that the structure allowed flexibility in allocating the benefits of participation in the partnership between the partners. This flexibility is now all but gone as a result of s HG 2(2) ITA 2007, which broadly deems all benefits of participation in the partnership to be allocated to partners according to their partnership share in the income of the partnership. This allocation rule applies to any amount of income, tax credit, rebate, gain, expenditure or loss from a particular source, or of a particular nature, accruing to the partnership.

A partner's partnership share in the "income" of the partnership (as distinct from a share in any other right or property) must be used as a basis for attributing any benefit flowing from the partnership to partners. There appears to be some uncertainty as to whether the concept of "income" in s HG 2(2) refers to an amount that is income under Part C of the ITA 2007, or whether this term is a wider commercial concept of income that may include gains or amounts that may not be treated as assessable income under the ITA 2007. However, it would seem sensible that the concept of "income" refers to income under Part C, with the consequence that all deductible expenditure, capital losses, capital gains, tax credits and rebates of a partnership are to be attributed according to the percentage of assessable gross income that the partner is entitled to.

The allocation rule in s HG 2(2) means that it may not be possible for certain types of benefit to be streamed to partners in the partnership who are in the best position to derive that benefit. For example, where two partners, one of whom is tax exempt and one of whom is a 30% taxpayer, agree to allocate income on a 70/30 basis, any capital gains generated by the partnership must also be allocated between the partners on a 70/30 basis, even though it may be advantageous for as much of the capital gain to be allocated to the taxpaying partner. The allocation rule also limits the ability to stream foreign-sourced income to non-resident partners in order to minimise the New Zealand tax impost on that particular source of income.

Importantly, the anti-streaming rule does not apply to expenditure or loss that an entering partner has as a consequence of acquiring an interest from another partner, but only to the extent that the safe harbour rules do not apply. An example of where this exception will have practical application is where a new partner acquires an interest in depreciable property from an exiting partner in circumstances where the safe harbour rules (to be addressed in a later article) do not apply. In this case, the new partner may obtain a step-up in the cost base for the relevant share of the depreciable property, entitling that partner to a greater proportional amount of depreciation loss than other partners in the partnership that maintain the original cost base for the property.

The anti-streaming rule also has no application to supplementary dividends and conduit tax relief additional dividends, presumably on the basis that those "dividends" must be payable to non-residents only to achieve the relief purposes of those respective tax regimes.

* This is the first in a series of three articles addressing the law relating to the taxation of general and limited partnerships.