2015-0588791I7 Meaning of substituted property

Principal Issues: Whether partnership units in a Delaware limited partnership can be considered to be identical property to the shares of a Delaware limited liability company.

Position: No.

Reasons: The inherent qualities and elements of the units in a Delaware limited partnership are not the same as those in a Delaware limited liability company.

Author: Ho, Judy
Section: 40(3.3), 40(3.4), 40(3.5)

                                                                                                          February 3, 2016

                                                                                                         Headquarters
                                                                                                         Income Tax Rulings
XXXXXXXXXX TSO                                                                        Directorate
                                                                                                         Judy Ho
                                                                                                         (416) 973-0020

                                                                                                         2015-058879

Meaning of Substituted Property - Subsection 40(3.3)

We are writing in response to your request for our views regarding whether units in a Delaware limited liability company (“DLLC”) can be considered identical property to units in a Delaware limited partnership (“DLP”) in the context of the stop-loss provisions in subsections 40(3.3) and 40(3.4), as it applies to the conversion of DLLC into DLP described below (the “Conversion”).

Unless otherwise stated, all references to a statute are to the Income Tax Act (Canada), R.S.C. 1985, c.1 (5th Supp.), as amended to the date of this letter (the “Act”), and every reference herein to a section, subsection, paragraph, subparagraph or clause is a reference to the relevant provisions of the Act.

Our understanding of the facts relevant to the situation you are considering is as follows:

1.    US LP is a limited partnership formed under the laws of Delaware and a Canadian partnership as defined in subsection 102(1).  US LP elected to be treated as a corporation for U.S. tax purposes.

2.    Immediately prior to the Conversion, US LP held 100% interest in LLC1, LLC1 held 49.9% of the units in LLC3, and LLC2 (a wholly-owned subsidiary of LLC1) held 0.1% of the units in LLC3. The remaining 50% of the units in LLC3 were held by a third party.  LLC1, LLC2 and LLC3 were all fiscally transparent entities for U.S. tax purposes.

3.    On XXXXXXXXXX, the Conversion was implemented through the conversion of LLC3 (a DLLC) into US LP2 (a DLP) pursuant to Section 17-217 of the Delaware Limited Partnership Act (“LPA”).  For U.S. federal income tax purposes, the Conversion was treated as a continuance of LLC3 as a DLP. However, for Canadian income tax purposes, the Conversion resulted in the disposition by LLC1 and LLC2 of their respective units in LLC3 and the acquisition by LLC1 and LLC2 of units in US LP2. As a result of the disposition of the units in LLC3, LLC1 recognized a foreign accrual property loss.

Our Comments

Subsection 40(3.4) applies to suspend the recognition of a capital loss where the conditions described in subsection 40(3.3) are met. In regards to the Conversion, paragraph 40(3.3)(b) requires that, during the period that begins 30 days before and ends 30 days after the disposition by LLC1 of its units in LLC3, LLC1 (or a person affiliated with LLC1) does not acquire the membership units in LLC3 or any property that is identical to the membership units in LLC3.  Therefore, the question is whether the partnership units in US LP2 that LLC1 holds after the Conversion can be considered property that is identical to the units in LLC3 held by LLC1 immediately prior to the Conversion.

As indicated above, the Conversion resulted in the disposition by LLC1 of the membership units in LLC3 and the acquisition of partnership units in US LP2, which is consistent with our views expressed in Document 2004-0104691E5. In that document, we also concluded that membership units in a DLLC are not the same property as partnership units in a DLP for Canadian income tax purposes.

IT-387R2 “Meaning of Identical Properties” states that identical properties are properties which are the same in all material respects, so that a prospective buyer would not have a preference for one as opposed to another. In determining whether properties are identical, it is necessary to compare the inherent qualities or elements which give each property its identity.

Based on your description of the inherent characteristics of the membership units in LLC3 and the partnership units in US LP2, it appears that despite certain similarities, the two properties still have certain differences in inherent qualities and elements. Among such differences (see also document 2004-0104691E5 for a more detailed discussion) are:

-     the personal liabilities of the participants of DLLC and DLP;
-     the management rights in the affairs of DLLC and DLP;
-     the tax treatment of distributions from DLLC and DLP; and
-     the ownership of properties held by DLLC and DLP.

These differences in inherent qualities and elements could result in a prospective buyer to have a preference of one property over the other, which would then result in the membership units in DLLC and the partnership units in DLP not being considered identical properties.

Subsection 40(3.5) contains special rules to deem certain property to be “identical property” for the purposes of the stop-loss rule in subsection 40(3.4). The Act recognizes that there are situations in which it would be appropriate from a tax policy perspective to treat certain properties as being identical, even though the properties would not otherwise be identical properties. The conversion of an entity from one legal form to another, such as the conversion from a DLLC to a DLP, is not one of the situations covered in subsection 40(3.5).

The economic similarities between the LLC1’s economic situation before and after the Conversion cannot be taken into account as this is not an inherent quality or element of the properties themselves.  In 10737 Newfoundland Limited v. Her Majesty the Queen (2011 TCC 346), the court concluded that even though the exchangeable shares in that situation were economically equivalent to the shares received in exchange for the exchangeable shares, the taxpayer still incurred a loss that should be recognized for tax purposes.

Based on the foregoing reasons, the membership units in DLLC and the partnership units in DLP are not identical properties because they have different inherent qualities and elements and they are not deemed to be identical properties under subsection 40(3.5).

We hope our comments are of assistance to you.

Yours truly,

Vitaliy Anissimov
Section Manager
For Division Director
International Division
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch

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