Since joining the cross border team at Moodys, I’ve had opportunities to help clients navigate US tax law and hear “O Canada” even when neither the Flames nor the Oilers are in town. For US purposes, allocations of US partnership1 income are reported to the IRS on a Form K-1 issued to the partners in the partnership. In Canada, the corresponding form is a Form T5013, which reports allocations of partnership income among partners in: (a) a Canadian partnership; (b) a partnership that carries on a business in Canada; or (c) a certain type of partnership whose units are publicly traded. I’ve also learned that (mimicking the mph/kmh conversion of speedometers) many Canadian accountants and taxpayers simply report their US partnership income to the CRA by converting the US dollar amounts on a K-1 to Canadian dollar amounts on their T1 or T2 (or corresponding form). This practice, although common, ignores important differences between the two sets of tax laws and can have legal ramifications. Over time, we will explore many of these differences.2 This first installment addresses the different Canadian and US treatments of certain partnership debt.
For US tax purposes, all debt (both recourse and non-recourse) of a partnership is allocated among the partners in the partnership (generally through a “deemed” increase in the amount the partners have spent to acquire their partnership interest and/or contribute capital to the partnership). This increases each partner’s ability to deduct items of partnership expense and depreciation. However, for Canadian tax purposes, not all partnership debt is allocated among the partners. This difference is illustrated as follows:
“USCO 1 and USCO 2 form a US limited partnership (USLP) with CANCO 1. USCO 1 is the general partner. USCO 2 and CANCO 1 are limited partners. Each partner contributes $10 cash to USLP. USLP borrows $60 from a third party disinterested lender on a non-recourse basis to purchase equipment. Under US partnership tax principles, each partner is credited with an aggregate $30 of cost and capital contributions with respect to their USLP interest, consisting of their $10 contribution increased by their $20 ($60/3) allocation of partnership debt.3 However, for Canadian income tax purposes, CANCO 1 has only a $10 ACB in its USLP interest because the Income Tax Act does not treat the non-recourse partnership debt as “allocable” to CANCO 1. Further, assume USLP has $45 of losses in its first year. For US purposes each of the partners can claim their entire $15 proportionate share of losses. However, for Canadian purposes, CANCO 1 will only be able to claim the amount that it has “at risk”, which in this example is the $10 ACB which it has in its USLP interest.”
US professionals keeping the partnership books may not realize (or recognize) the need to provide specialized tax reporting and financial information to Canadian partners. Yet, CANCO 1 cannot simply rely on the K-1 it receives to report its share of USLP income for Canadian tax purposes. Differences in partnership tax accounting also opens a Pandora’s Box of further possible complications. The year of recognition for partnership tax items will differ for Canadian and US purposes. This timing difference may cause a mismatch of foreign tax credits and could complicate any sale of an interest in the partnership. Enterprising investors and tax advisors will recognize potential savings in the wrinkles of these complications, specially if they have identified the issue. As always, identifying the issue is the first step in adding to the client’s bottom line.
1. The different approaches taken by the two countries’ tax laws to determine partnership residency merits its own discussion.
2. It is important to note the many potential pitfalls to Canadians investing in US LLC’s, which are also treated as “partnerships” for US income tax purposes. These issues have previously been discussed on this blog _ https://www.moodystax.com/canadians-beware-united-states-limited-liability-companies-may-be-hazardous-to-your-tax-health.
3. Assume that this allocation is the result of the three tier allocation process provided for in Treas. Reg. 1.752-3(a).