Private equity funds and limited partnerships
Private equity funds almost always operate as limited partnerships (LPs). The LP structure is simple but effective: The fund manager, usually a corporation, manages the business as the general partner and assumes unlimited liability. The investors in the fund take on a passive role as limited partners and enjoy limited liability.
LPs are preferable to corporations because income generated by an LP is taxed only in the hands of the partners (the investors), whereas income generated by a corporation is taxed at both the corporate and the individual levels.
Not all limited partnerships are equal...at least not in Canada
Partnerships classified as "Canadian Partnerships" under the Income Tax Act are granted additional tax benefits, including:
- exemptions from withholding tax obligations;
- tax deferral for contributions made by partners; and
- tax deferral for distributions made on dissolution.
In order to qualify as a Canadian Partnership under the Income Tax Act, all partners must maintain Canadian tax residency. Yes, all partners. Having a single non-resident partner disqualifies an LP from being a Canadian Partnership.
If a Canadian fund were to inadvertently take on a non-resident investor, or if a previously resident investor were to change his or her tax residency, not only would the fund lose the preferred tax treatment afforded to Canadian Partnerships, but it would also be required to disclose to investee companies that it is no longer a Canadian Partnership. Investee companies could, in turn, face onerous withholding and reporting obligations. Not good for business.
Steps for maintaining Canadian Partnership status
A simple yet effective approach is to require that all partners maintain Canadian tax residency status. This can be a matter of policy, or it can be set out directly in the partnership agreement.
It is equally important for fund managers to use comprehensive vetting procedures when considering new investors, as the tax residency of a prospective investor is not always immediately apparent. For example, a prospective investor that is itself a partnership may not raise any red flags in the mind of the fund manager, particularly if the investor partnership is registered in Canada. If, however, the investor partnership has — or comes to have — a single non-resident partner, then it will be treated as a non-resident person for the purposes of establishing whether the fund qualifies as a Canadian Partnership.
Taking on non-resident investors
For funds not wanting to put geographic restrictions on their pool of potential investors, there are two ways to maintain Canadian Partnership status while still allowing for foreign investment; although, each comes at a cost.
The simplest solution is to require foreign investors to establish a Canadian corporation to hold the interest in the fund. As long as the corporation is a tax resident, the fund will continue to qualify as a Canadian Partnership. The obvious disadvantage of this approach is that requiring foreign investors to create a Canadian corporation will invariably discourage some amount of foreign investment.
An alternative solution is to establish a separate parallel fund designated specifically for foreign investors. Under this structure, the resident fund keeps the tax benefits afforded to Canadian Partnerships, while the non-resident fund remains attractive to foreigners not wanting to jump through hoops to invest. The disadvantage of this approach is that the additional tax reporting and withholding obligations of the non-resident fund can effectively increase the cost of investing; albeit less so than mixing the two groups.
Ultimately, there is no one-size solution for handling foreign investment. It is therefore important to have trusted advisors who can help tailor your agreements and policies to the unique needs of your business.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
