Tax Law Note: What Basic Approaches have Countries taken to Taxing Partnership Income?

Tax Law Note:
What Basic Approaches have Countries taken to Taxing Partnership Income?

Legal Department

Last Updated: December 02, 2004

Introduction

Forms of business partnership are recognized in both common law and civil law countries; however, the definitions and basic legal features vary significantly.

In common law systems, a partnership is defined as an essentially contractual relationship among persons to pursue a common business. Partnerships are generally not considered as persons for legal purposes. Civil law systems typically do not use the term partnership but they do have the concept of an association of persons for business purposes, in distinction to capital companies, which are viewed rather as a concentration of capital.^¹ Many civil law jurisdictions also make a distinction between a civil law partnership and a commercial law partnership.²

The income of a partnership is either taxed at the level of the partnership, in a manner equivalent to or similar to the taxation of companies, or in the hands of the partners according to the rates applicable to them ("flow through" treatment).

In systems with flow through treatment there are two basic approaches to calculating and taxing the income of partners. The "entity approach" views the partnership as an entity separate from its partners. The income is calculated at the level of the partnership and then is allocated to the partners. The "aggregate approach" views the partnership as an aggregation of the partners, with each partner holding a fractional ownership interest in partnership assets. The partnership is not considered as an entity that exists separately from its partners. The taxable income therefore is not determined at the level of the partnership but is calculated for each partner separately. The two approaches can rarely be found in their pure form; it is more common to see hybrid solutions which combine the two approaches.³ This makes the taxation of partnerships conceptually complex in any system applying flow through treatment.

Country Practices

While the details of partnership taxation can be extremely complex and much variation can be found among countries, some general patterns can be identified.

1. Partnerships as taxable entities

Partnerships are generally treated as legal persons in most civil law jurisdictions with the exception of certain type of partnerships (such as civil law partnerships).⁴ Some countries treat partnerships with legal personality as taxable persons (e.g. Belgium and Spain). In others partnerships are treated as flow through entities even if they have a legal personality.⁵ In common law countries partnerships do not have a legal personality and are usually taxed on a flow-through basis.⁶

A few countries (especially transition countries) treat all partnerships as taxable persons.⁷

2. Flow through treatment of partnerships

Countries that tax partnerships on a flow-through basis use the entity approach, the aggregate approach, or some combination of the two in determining the amount of income allocable to each partner. Few countries apply a pure version of either of the two polar approaches (entity vs. aggregate).⁸ In those countries where small businesses corporations⁹ are taxed on a flow-through basis, the general approach may be closer to the entity approach. In the U.S., this is facilitated by requirements that, in order to qualify for flow-through treatment, corporations must have only one class of stock. This makes it relatively easy to allocate income of the corporation on a pro rata basis to shareholders.

The allocation of income under the partnership agreement is usually followed also for tax purposes. The allocation may be based on the proportion of capital contributed or may be based on the expertise or effort of the partner or the particular property contributed. Allocation of income under the partnership agreement may not be respected if it is not at arms length.¹⁰

One practical problem is posed by deductions with respect to which the taxpayer must make an election, for example depreciation which is accelerated at the option of the taxpayer. Under the entity approach, these elections are made at the entity level, while under the aggregate approach each partner must make a separate election.¹¹

Countries tending to the aggregate view do not allow the deduction of salaries on the basis that a partner cannot be his or her own employee.¹² In countries using the entity approach salaries may be deducted when calculating the partnership income.¹³

Upon formation of the partnership in countries that use the entity or a hybrid approach the contribution of property is generally treated similarly as a contribution to a company. Typically under these rules the partner realizes no gain or loss and the partnership has a cost basis in the asset that is equal to the cost basis of the contributing partner at the moment of the contribution. In countries adopting an aggregate approach, in principle a fraction of the contributed property continues to belong to of the contributing partner.¹⁴ However, it is administratively difficult to apply a pure version of the aggregate approach in this respect.

With respect to losses the main question that arises is whether or not a partner may deduct a partnership loss from other income of the year. Some countries in effect treat the partnership like a taxable entity for this purpose and allow it only to carry over the loss and use it to offset against partnership income of other years.¹⁵ Other countries allow partnership losses to be deducted from other income of the partner.¹⁶ Some countries restrict the amount of loss that may be claimed to the tax cost of the partner's partnership interest¹⁷ or the amount the partner has at risk.¹⁸

Under the general (nonpartnership) rules, certain types of income may be subject to special tax treatment (e.g., interest or capital gains). An issue that arises with respect to partnerships is whether the character of the income received by the partnership is maintained in the hands of the partners. Under the pure aggregate treatment all income and cost items flow through to the partners, thereby maintaining their character.¹⁹ In countries using a hybrid approach, the character of income is determined at the partnership level but income allocated to the partners retains its character.²⁰ In countries that use the pure entity approach the income is calculated at the level of the entity and the net amount is allocated to the partners as a single category of income, usually business income.²¹

When a partnership interest is disposed of, in countries using the aggregate theory the partner is regarded as selling a fraction of all partnership assets. The gain or loss is computed and the character of the income is determined at the level of the disposing partner.²² Some countries regard partnership interests as a special kind of asset without looking through to the character of the actual asset sold.²³

Distributions to partners are not taxed in most countries, given that the income being distributed has been taxed already.²⁴ In other countries withdrawals of assets from the partnership by individual partners are taxed if it is considered that a business asset is withdrawn from business use.²⁵

In jurisdictions where partnerships are not taxable entities, the tax residence of partnerships is generally not relevant; what is important is the residence of the partners.²⁶

In many countries partnerships are required to file tax returns even if no income tax is levied at the level of the partnership.²⁷

Fashioning a Solution

Treating partnerships as taxable persons is simpler from an administrative point of view than taxing the income in the hands of the partners. This is because tax has to be collected only from one person instead of various, and the tax returns of individual partners are kept simpler. Additionally, as all business entities are usually subject to the same rate of tax, entity level taxation ensures that the choice of taxpayers between different types of entities is based on commercial or other considerations and not motives related to taxation. The disadvantage of this approach is that income is taxed at the flat corporate tax rate instead of applying the tax rates applicable to individual partners.²⁸

Given that some but not all countries decide to treat partnerships as taxable persons, discrepancies may result if foreign partnerships are also viewed as taxable entities for tax purposes. For example suppose that country A regards partnerships as taxable entities. Suppose further than individual residents of country A are partners in a partnership established in country B. Country B treats partnerships as flow through entities. The partnership receives income from sources outside of country B, thus country B does not tax the income as the partners in the partnership are not residents of country B. At the same time country A does not tax the income of the partnership in the hands of the partners resident in country A because it regards the partnership as a taxable entity and would only tax the partners when the income is actually distributed to the partners in country A. Thus, if there is no distribution, the income is not taxed in either country B or country A.

Where partnerships are taxed on a flow-through basis, the rules for doing so inevitably involve some complexity; further complexity arises when anti-abuse rules are fashioned. While the appropriate solution will depend on the specific tax rules of each country, as a general matter it can be said that a relatively consistent use of the entity approach in applying flow-through taxation will likely minimize complexity.

The series of Tax Law Notes has been prepared by the IMF staff as a resource for use by government officials and members of the public. The notes have not been considered by the IMF Executive Board and, hence, should not be reported or described as representing the views of the IMF or IMF policy.
¹See Victor Thuronyi, Comparative Tax Law 279 (Kluwer 2003).
²Associations governed by civil law generally have a contractual nature and are not considered to have legal personality. Commercial associations (governed by commercial law) may or may not have legal personality. Id.
³Alexander Easson & Victor Thuronyi, Fiscal Transparency, in Tax Law Design and Drafting 933 (IMF 1998) [hereinafter TLDD].
⁴It is so, for example, in Spain, France (except for societé de fait and societé en participation), Mexico, Brazil, Russia, Hungary and Czech Republic. Exceptions are Belgium, Indonesia, Japan, and the Netherlands. See Jean-Pierre Le Gall: General Report, International Tax Problems of Partnerships, 80a Cahiers de droit fiscal international, 655, 87, 113, 207, 267, 317, 377, 395, 457, 483 (1995) [hereinafter Cahiers].
⁵E.g., Argentina, Denmark, France, and the Scandinavian countries. See TLDD, supra note 3, at 929.
⁶In some common law countries certain kind of partnerships that resemble limited companies are taxed as entities: e.g. in Australia certain limited partnerships or in the U.S. certain publicly traded partnerships. U.S. IRC sec. 7701; TLDD, 930. In Indonesia partnerships are taxed as entities even though they do not have legal personality. Cahiers, 267; TLDD 930.
⁷Examples are Kazakhstan, Romania, and Hungary. See TLDD, supra note 3, at 930; KAZ TIC §6(3), ROM PT § 1(1)(a), HU TAO §2.
⁸Denmark and the Netherlands come closest to using a pure aggregate approach, while Finland and Norway are examples of the entity view. The U.S. and Germany are examples of countries that use a hybrid of the two approaches. See TLDD, supra note 3, at 928, 934.
⁹In the U.S., so-called Sub S corporations.
¹⁰In Australia and Canada the agreement of the partners regarding allocation of income may be disregarded if the parties are related and may be substituted by a reasonable allocation. See id. at 935.
¹¹Partners make separate decisions regarding certain deductible items in Denmark and the Netherlands. See TLDD, supra note 3, at 936; Cahiers, supra note 4, at 159, 397.
¹²Examples are Australia, the U.K., Denmark and Israel. See TLDD, supra note 3, at 937.
¹³The U.S. allows the deductions of salaries for services rendered other than in the capacity as a partner. U.S. IRC § 707 (a).
¹⁴See TLDD, supra note 3, at 944, 945.
¹⁵This is the treatment of partnership losses in Finland. See TLDD, supra note 3, at 937; Cahiers, supra note 4, at 185.
¹⁶Australia, Canada, U.K. See TLDD, supra note 3, at 937.
¹⁷This is the case in Canada and Sweden in the case of a limited partner. See id. at 937.
¹⁸The U.S. and Canada. See U.S. IRC § 465; Cahiers, supra note 4, at 128.
¹⁹This treatment prevails in Denmark. See TLDD, supra note 3, at 940; Cahiers, supra note 4, at 159-60.
²⁰Examples are the U.S. and in a simpler form Canada. See TLDD, supra note 3, at 940; U.S. IRC § 702, CAN ITA § 96 (1).
²¹See TLDD, supra note 3, at 940.
²²This is the approach taken in Denmark and to some extent in Japan. See id. at 943.
²³This treatment prevails in the U.S. except for some "hot assets". See id. at 943; U.S. IRC § 751.
²⁴Canada, U.K., U.S.. See TLDD, supra note 3, at 945.
²⁵E.g.,. Germany. See id. at 945.
²⁶ In the U.S. for example if a domestic partnership has foreign partners, there is no withholding on payments to the partnership, however the partnership has to withhold the corresponding tax on items of income that are included in the distributive share of the foreign partner. U.S. Treas. Reg. § 1.1441-5(b)(2).
²⁷For example in Australia, Singapore, South Africa, Sweden. See TLDD, supra note 3, at 933.
²⁸See id. at 930 - 931.

NOTE: The series of Tax Law Notes has been prepared by the IMF staff as a resource for use by government officials and members of the public. The notes have not been considered by the IMF Executive Board and, hence, should not be reported or described as representing the views of the IMF or IMF policy.