In the first of two articles, Aylton Jamieson, Assistant Tax Director, looks at the tax implications of losing a business partner. Next month he will look at the implications of adding a partner.
WHAT is the correct income tax treatment of a surviving partner's interest when a business partner dies or retires? Current practice seems to vary depending on the size of the partnership, the wording of the partnership agreement, the nature of the partnership assets and, not least, the likelihood of investigation!
SummaryFrom a strict legal perspective it appears that when a partner dies or retires and the partnership continues, then the old partnership is terminated and a new partnership is formed. While there are specific provisions within the Income Tax Act 1994 that trigger depreciation recovery and trading stock implications for the partnership, there may be an issue of whether they apply to a surviving partner's continuing interest. There are different options on how to treat the trading stock for surviving partners, and although the depreciation recovery provisions are not applied per se to the surviving partners, they have implications for their carrying values. In theory these provisions should apply to all partnerships, but in practice there are further distinctions based on whether the partnership is large or small. In practice, if the partnership is large, any partnership reorganisation is ignored. The uncertainty and possible liability, however, still exists for small partnerships. One possible step which partnerships can take is to include a term in the partnership agreement that the partnership will continue in the event of the death of a partner. This (arguably) does not prevent the termination of the old, but it may impact on the economic outcome of the change and could be taken into account by Inland Revenue.
Valabh CommitteeBack in 1989 the Valabh Committee said:
(1)The main issue is the consequence of a reconstitution of a partnership by the admittance of a new partner and/or the death or retirement of an existing partner. This is an area of some confusion and practice tends to be dominated by past procedures rather than arguments on the finer points of law. The Valabh Committee noted that from a legal perspective it is likely that:
- A partner does not own specific assets that make up the overall partnership property.
- Each partner owns a proportionate share of the overall assets of the partnership.
- When a partnership is dissolved and a new partnership consisting of the remaining partners is formed, then the reconstitution could arguably result in a disposal of all partnership assets with a resulting tax liability realised by the disposal of the assets.
- Disposal would arguably occur even if a partnership deed had a contrary provision because for income tax purposes, a new partnership (or "person") comes into being.
The Valabh Committee noted that there were some specific provisions within the Income Tax Act that dealt with reconstitution of partnerships. It noted that in practice:
- New partners were treated as purchasing their share of the partnership from the other partners.
- Where an existing partner retired or died, the other partners were treated as having purchased the retiring share of partnership assets.
- Inland Revenue did not [and probably still does not] assert that partnership reconstruction results in the complete sale of total partnership assets so that taxable gains are realised by continuing partners.
The Valabh Committee presented a number of alternatives in its 1991 paper
(2) and recommended some pragmatic solutions in its 1992 paper
(3) as follows:
- If a partnership has six or more members and the change in ownership is not greater than 34%, or if there was no intention to sell the assets to third parties, then a reconstruction of that partnership should be ignored for tax purposes.
- Where a partnership has fewer than six members and the criteria applying to larger partnerships was met, then a partnership could apply to the Commissioner to have a reconstruction ignored.
A decade later, none of the recommendations that the Valabh Committee made on partnership reconstructions have been implemented. So the strange uncertainty that the Committee described in 1989 continues.
AnalysisPartnership legislation Section 36(1) of the Partnership Act 1908 provides that: Subject to any agreement between the partners, every partnership is dissolved as regards all the partners by the death or bankruptcy of any partner. Based on that subsection, taxpayers could argue that they can make a provision in their partnership agreement that the partnership will continue whether or not a partner dies.
There is, however, an argument against that interpretation based on very strong precedent. The House of Lords in IRC v Gibbs [1942] AC 402 was faced with an issue under UK tax law regarding the addition of a further partner, and concluded that the previous partnership had finished. It held that:
Under English Law (as opposed to Scottish Law), the business is carried on by the individual partners jointly and not by the partnership. The partnership is not a single legal person. In one sense the previous partners may not cease to carry on the business, but the business is not the old business. The old business is superseded by a new business with a different division of property ownership, powers of agency, representative capacity and other rights associated with a partnership.That decision was made on the basis of legal partnership principles and is not limited to UK tax legislation. The decision has been cited with approval in New Zealand by the High Court in two cases: Hadlee & Sydney Bridge Nominees v CIR
(4) and Cooper v CIR.
(5) Hadlee (albeit obita) also stated that even if partners were to agree that the partnership would continue after the death of one of the partners, the partnership practising the day after the person died would be a different partnership than that which had practised the previous day.
A possible way to distinguish the precedent of the Gibbs and Cooper cases from the interpretation based on section 36(1), is that they were increasing the partnership numbers. Therefore, even if the partners had made an agreement in either of these cases that the partnership would be continued by the surviving partners, despite the death or retirement of a partner, section 36(1) would not have applied. It can also be argued that when it passed the Partnership Act, Parliament would have known that if a partner died, the partnership would have been reduced by one member. Therefore, it could be argued that section 36(1) is a special rule that exists where a partner leaves the partnership in involuntary circumstances.
On balance, we consider it is likely that a Court would consider that the death of a partner would result in the formation of a new partnership.
The large partnership/small partnership differenceAs the Valabh Committee noted, in practice there is different treatment for large professional partnerships. We cannot state exactly why this occurs, but the following factors seem important.
- In many cases, large partnership deeds state that partners are not entitled to a share of the partnership's assets. We understand that this is sometimes achieved structurally by having the partnership assets owned by a company or a trust with the partners indirectly linked. (6) These partnerships are treated like an entity in their own right, so the change of a partner is treated more like the sale of a share in a company.
- . Another reason that has been given (7) is the practical problems that would arise with all the partners having different cost bases for trading stock and depreciable property.
- In some big partnerships, the partners do not pay any consideration upon entering a partnership or receive a payment when leaving the partnership. In Australia that factor is important for capital gains purposes. (8)
- With regard to small partnerships, we understand that Inland Revenue does not assert that the death of a partner results in the complete sale of all partnership assets so that taxable gains are realised by continuing partners. (9) We understand that Inland Revenue is more concerned in general with the tax implications of the partners who are either disposing of their interest or acquiring an interest. For that reason, the following factors need to be considered:
Does the partnership agreement provide for the partnership to continue in the event of the death of a partner? (The TEO argued that this may impact on the economic outcome of the change and can be taken into account in determining the tax consequences of the result.) (10) Is there any change to an existing partner’s interest? How will any new partner treat the acquisition?As small partnerships constitute the majority of partnerships in New Zealand, their tax treatment has major implications for taxpayers.
Specific tax provisionsTo understand the implications for a surviving partner, it is also necessary to consider the effect of any provisions in the Income Tax Act 1994 (the ITA) which apply to those partners.
General meaning of disposalThere are a number of provisions within the ITA in which a disposal will trigger a taxable event. Examples of this include personal property,
(11) land,
(12) forestry,
(13) trading stock
(14) and depreciable assets.
(15) Does the death of a partner trigger a "disposition" for tax purposes? As noted in a previous article
(16) the word "disposition" was initially interpreted very broadly. In recent times, however, the New Zealand Courts have given the word a more restricted meaning based on the context of the word: namely intention and activity on the part of the person selling or disposing
(17) or, in the land sales context, sales, assignment or transfer.
(18)In the context of the death of a partner in a partnership, it would not be possible to argue that there was intention or activity on the part of the deceased. In addition, the Full Court of the High Court of Australia held in the Rose case
(19) that when a father admitted two sons into partnership with him, that did not constitute a "disposal" of the whole or part of the assets of a business. While that is the general position in relation to "disposal", there have been a large number of changes to particular provisions within the ITA, which means that the general position does not apply.
DepreciationDoes the death of a partner trigger a "disposition" for depreciation purposes? There is a specific provision (section EG 19(8) of the ITA) that means the depreciation recovery provisions will apply upon the "formation or dissolution of a partnership" or any "variation in the constitution of a partnership, or in the interests of partners".
There may be an issue as to how effective that amendment was in relation to surviving partners. From a technical perspective there is nothing in EG 19(8) which requires the partnership to be treated as the disposing entity. Indeed, that subsection refers to "a taxpayer" selling or otherwise disposing of a share or interest in any property. As a partnership is not a "taxpayer" for income tax purposes, the section is referring to the individual partner who sells or disposes of the property.
(20) Based on the Rose case and the mutuality principle, there could be arguments that the depreciation recovery provisions only apply to the extent that the individual partner’s interest has changed.
Inland Revenue does not consider that this results in a complete depreciation clawback for a surviving partner or partners, but those partners will commence with a new depreciation carrying value. For an example of how Inland Revenue would apply this to a surviving taxpayer refer to TEO Newsletter #115.
In Australia, the Australian Tax Office allows the trustee of a deceased’s estate to be party to a joint election for roll-over relief for depreciated property.
(21) The new partnership (including the trustee) is allowed to continue depreciating the assets at their prior tax written-down value.
Trading stock (not livestock)The background is that the New Zealand High Court in Neil v CIR (1967) 10 AITR 407 applied the Rose case to the predecessors of sections FB 3 and FB 4, with the result that the trading stock provisions did not apply to the reorganisation of partnerships. Those sections were then amended by adding the words: This section shall, with any necessary modifications, apply in any case where a share or interest in any trading stock is sold or otherwise disposed of by any taxpayer. The intention of this amendment was to overcome the effect of the Neil case.
Section FB 3 (which deals with the disposal of trading stock) includes all forms of trading stock, but excludes financial arrangements and land. Section FB 4 (income derived from the disposal of trading stock together with the sale of other assets) applies to all things covered by section FB 3, and in addition includes forestry, real and personal property acquired for the purpose of resale, and land held on revenue account. There are a number of alternative ways to make a calculation for the surviving partners (See TEO Newsletter number 115.)
Accrual rulesPreviously there was an exposure that any partnership reorganisation would be subject to a base price adjustment (BPA).
(22) This situation has now been clarified by an amendment to the accrual rules which provides that an interest in a partnership or joint venture is an "excepted financial arrangement".
(23) These changes prevent the requirement for a BPA following a partnership reorganisation.
LivestockWhat happens to a surviving partner if a partner in a livestock partnership dies? Under section EL 1(3), the personal representative of the deceased is required to adopt a market value to the date of death. Under section EL 1(4), where the deceased is a partner in the partnership and the personal representative of the deceased carries on in partnership with the surviving partners, then the personal representative would still have to apply market value in the deceased’s return to the date of death. Inland Revenue considers that:
(24) Any increase or decrease in value of the livestock is treated as partnership income for the purposes of calculating the deceased’s return to the date of death. The adjustment that is made in the deceased’s return has no effect on the income of any surviving partner who continues in partnership with the personal representative. The surviving partner will use the same valuation method that was applied previously.The TEO considered that the death of a partner creates a new partnership, but the continuing partners maintain an undivided interest in the partnership assets. In respect of the continuing assets, there is no deemed sale by the old partnership and purchase by the new partners.
There is an anti-avoidance rule
(25) for specified livestock (sheep, diary cattle, beef cattle, deer, goats or pigs). In relation to a new partnership, that rule provides that if more than 50% of the property was owned by persons who previously owned all of the property of any other partnership, then the new partnership is required to use the same method of valuation as the old partnership.
As the TEO noted
(26) this section will only apply if the partnership expands (although the TEO recognised that this may not be the policy intent).
(27) The TEO pointed out
(28) that this anti-avoidance provision may not apply where the partnership is not expanded. It concluded that where the deceased partner’s share is sold to the remaining partners:
There is no change to the surviving partners’ original interests In respect of the deceased partner’s share the surviving partners will have to undertake a calculation for which the anti-avoidance rule will not apply To the extent that the new partnership is using National Standard Cost or Self Assessed Cost, this will impact on the calculations.ConclusionTaxpayers and advisers are uncertain of the tax treatment of a surviving partner following the death of a partner. As the Valabh Committee noted a decade ago, the current law may not match the practice that seems to be acceptable to Inland Revenue. The Institute has been asking for clarification of this issue over a long period. Inland Revenue has advised that it plans to start a review this year. This area begs the application of either some authoritative statements from Inland Revenue (possibly under the care and management provisions) or legislative reform.
This is a general summary only and should not be taken as a substitute for specific advice.
Originally published in the Chartered Accountant's Journal, reproduced by permission of the Institute of Chartered Accountants
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ICANZFootnotes: footnote 1 Consultative Document on the Taxation of Income from Capital, December 1989, paragraph 2.6.1.
footnote 2 Key Reforms to the Scheme of Tax Legislation, October 1991, paragraph 12.6.2.
footnote 3 Final Report of the Consultative Committee on the Taxation of Income from Capital, paragraph 5.4.
footnote 4 (1989) 11 NZTC 6,155, page 6,162.
footnote 5 (1995) 17 NZTC 12,216, page 12,219.
footnote 6 Final Report of the Consultative Committee on the Taxation of Income from Capital, paragraph 5.4.
footnote 7 TEO Newsletter, number 115, page 9.
footnote 8 Australian Tax Office Ruling, IT 2540, page 4
footnote 9 Consultative Document on the Taxation of Income from Capital, December 1989, paragraph 2.6.1.
footnote 10 TEO Newsletter, number 115, page 3
footnote 11 Section CD 4 of the ITA.
footnote 12 Section CD 1 of the ITA.
footnote 13 Sections DL 1 and CJ 1(2) of the ITA.
footnote 14 Sections FB 3 and FB 4 of the ITA.
footnote 15 Section EG 19 of the ITA.
footnote 16 Refer "Double Dipping at the Wake", Chartered Accountants Journal, February 2002 at pages 50-52.
footnote 17 Public Trustee v CIR [1961] NZLR 1034 and Railway Timber Co v CIR [1977] 1 NZLR 655.
footnote 18 Lyttelton Port Company v CIR (1996) 17 NZTC 12,557.
footnote 19 Rose v FCT (1951) 84 CLR 118, pages 123-124.
footnote 20 This argument may also apply in respect of section FB 3 & EL 1(4), but not section FB 4(3).
footnote 21 Taxation Determination 93/158.
footnote 22 The New Zealand Accrual Regime, Glazebrook, James, Glyn-Jones & Cole para 312 pp 97-98.
footnote 23 Section EH 14 definition of "excepted financial arrangement", para s (for Div 1 instruments) and EH 24 definition of "excepted financial arrangement" para m (for Div 2 instruments).
footnote 24 PIB 162 April 1987.
footnote 25 Section EL 1(2) of the ITA
footnote 26 TEO Newsletter number 115, pages 10-11.
footnote 27 This is on the basis that if the new partnership did not include all the old members, then it would not have owned "all of the property".
footnote 28 TEO Newsletter number 115, page 13.