Landowner Partnership Reconstruction

Overview

The reconstitution of a general law partnership or a tax law partnership may have different income tax, capital gains tax (CGT) and goods and services tax (GST) consequences that should be addressed in preparing a Partnership Reconstitution Deed.

A general law partnership may be reconstituted without the tax consequences associated with reconstituting a tax law partnership, a joint venture or co-ownership.

The Federal Commissioner of Taxation (FCT) accepts that the reconstitution of a general law partnership (but not a tax law partnership) is the continuation of the partnership so does not have any income tax, CGT or GST consequences other than for any retiring partner.

Contrary to the approach of the Commissioner of State Revenue Victoria (CSRV), the reconstitution of a general law partnership does not have duty consequences.

Reconstituting a general law partnership (e.g. of trusts or companies) without tax or duty consequences may encourage the establishment of landholding general law partnerships in Victoria.

Legislative references are to the Partnership Act 1958 (Vic) (PAV 1958), the Income Tax Assessment Act 1936 (Cth) (ITAA 1936), the Income Tax Assessment Act 1997 (Cth) (ITAA 1997), the A New Tax System (Goods and Services Tax) Act 1999 (Cth) (GSTA 1999), the Taxation Administration Act 1953 (Cth) (TAA 1953) and the Duties Act 2000 (Vic) (DAV 2000).

Character of a Partnership for tax purposes

Landowners may be taxed differently if objectively characterised as a general law partnership rather than as a tax law partnership, a joint venture or co-owners.

Broadly, landowners will objectively be considered to be:

  1. a ‘general law partnership’ where they are in receipt of income jointly derived from carrying on a business (or single venture) for profit;
  2. a ‘tax partnership’ where they are in receipt of income jointly;
  3. an unincorporated or non-entity ‘joint venture’ where the participants are compensated by a share of the output rather than joint or collective profits (GSTR 2004/2);
  4. ‘co-owners’ where they are not in receipt of income derived from an enterprise jointly (TR 93/32; GSTR 2004/6).

A general law partnership is the relationship that subsists between persons carrying on business in common with a view to a profit (sec. 5 PAV 1958; TR 94/8; GSTR 2003/13) and may include a single venture for profit (sec. 36(b) PAV 1958; United Dominions Corporation Ltd v Brian P/L [1985] HCA 49 at [6]).

A partnership for income tax, CGT and GST purposes is ‘an association of persons carrying on business as partners’ (i.e. a general law partnership) or ‘in receipt of ordinary or statutory income jointly’ (i.e. a tax law partnership) and a partnership is an ‘entity’ (sec. 995-1 ITAA 1997; sec. 195-1 GSTA 1999; TR 93/32; GSTR 2004/6).

A ‘tax law partnership’ exists for tax purposes only and does not alter the general law, so the partners do not have joint liability to third parties, other than to the FCT (sec. 444-30 TAA 1953; GSTR 2003/13 at [13]; GSTR 2004/6 at [11]).

The general law and tax law differences between a general law partnership and a tax law partnership should be addressed in a Partnership Deed.

Character of a General Law Partnership

A general law partnership interest is a peculiar, sui generis interest, which may result in favorable tax treatments upon reconstruction of the partnership.

A general law partnership is not a separate legal entity distinct from the partners (Rose v FCT [1951] HCA 68).

The entitlement of a partner to profits is a fractional interest in the partnership profits, which is not severable from the interest of a partner. The interest of a partner is an equitable interest in the partnership and an assignable chose in action. A partner has no title to specific property owned by the partnership, but has a proprietary interest in all property and a beneficial interest in the surplus of partnership assets upon dissolution. (FCT v Everett [1980] HCA 6 at [7], [8] and [15]; Sharp v Union Trustee Company of Australia Ltd [1944] HCA 35; Livingston v CSD (Qld) [1960] HCA 94).

The peculiar, sui generis, characteristics of an interest being an equitable chose in action with beneficial interests in the surplus on dissolution has caused uncertainty in the correct tax treatment of reconstituting a general law partnership.

The partners may vary their inter se rights (but not third party rights: Beckingham v Port Jackson and Manly Steamship Company (1957) 57 SR (NSW) 403 at 410) and agree in a Partnership Deed to:

  1. contribute capital and divide entitlements to income disproportionately to capital (e.g. fixed or priority draw partners, capital partners) (sec. 28 PAV 1958);
  2. acquire partnership assets which are recorded in the partnership accounts or permit use of a partner’s asset by the partnership which are not recorded in the partnership accounts (sec. 24 PAV 1958; ATO ID 2004/955);
  3. lend money to or borrow money by the partnership (including interest free) which are recorded in the partnership accounts (FCT v Roberts & Smith [1992] FCA 543TR 95/25); and
  4. reconstitute rather than dissolving and winding up the partnership (sec. 36 PAV 1958).

These inter se rights are usually addressed in a Partnership Deed and should be addressed in the Partnership Reconstitution Deed to achieve particular desired favourable tax outcomes.

Character of a Tax Law Partnership

A tax law partnership does not have any capital, so the entitlements of a partner in a tax law partnership is an interest in the property coupled with a right to share the net income or loss (GSTR 2004/6 at [103]).

Accordingly, there can be no financial supply of capital by the partners or the partnership for GST purposes.  There being no partnership capital, a tax law partnership cannot be reconstituted (GSTR 2004/6 at [220] - [225]).

However, the partnership may make taxable supplies of any partnership assets (GSTR 2004/6 at [104] and [107]) that may be a supply of a GST free going concern (GSTR 2004/6 at [175]).

Income Tax, CGT & GST Treatment

The reconstitution of a general law partnership or a tax law partnership may have different income tax, CGT and GST consequences that should be addressed in preparing a Partnership Reconstitution Deed.

While a partnership must prepare an income tax return (sec. 91 ITAA 1936; PSLA 2011/15) not all income and expenses are included in the return and attributed to the partners (sec. 92 ITAA 1936).

Generally, each partner is treated as having an interest in the net income and assets of the partnership while the partnership is not regarded as a separate entity with separate tax consequences (aggregate approach) (FCT v Happ (1952) 5 AITR 290).

However, for some tax purposes, the partnership is treated as a separate entity with obligations independent of the partners and separate tax consequences (entity approach) (Rowe v FCT 82 ATC 4243; (1982) 13 ATR 110).

For CGT purposes, CGT events occur in relation to the partners and not separately for the partnership under the aggregate approach.  Accordingly, a partner is subject to tax on CGT event in respect of partnership assets and the gain is excluded from partnership income (sec. 106-5 and sec. 108-5 ITAA 1997).

For income tax, provisions that impose tax or require tax elections on an ‘entity’ basis (such as trading stock and depreciable assets) transactions occur in relation to the partnership as a separate entity independent of the partners under the entity approach.

For example, depreciable assets are treated as disposed of by the original partnership to the reconstituted partnership under the entity approach for market value rather than terminating value, unless the partners that own the depreciable assets before and the partners that own the depreciable assets after jointly agree in writing within 6 months to use the same method and effective life (sec. 40-340 ITAA 1997).

Similarly, trading stock is treated as disposed of by the original partnership to the reconstituted partnership under the entity approach for market value rather than cost, unless the partners that owned the trading stock immediately before hand (between them) continue to own at least 25% by market value and agree in writing with the partners that own it immediately afterwards to use the cost method of valuation (sec. 70-100 ITAA 1997; FCT v Westraders P/L [1980] HCA 24).

Where more than 75% of the partnership interests will be reconstituted, the reconstitution may need to occur in tranches to maintain at least 25% continuity of ownership between tranches.

Again, work in progress is treated as disposed of by the original partnership to the reconstituted partnership under the entity approach with any payment assessable income of the original partnership (sec. 15-50 ITAA 1997) and deductible to the reconstituted partnership (sec. 25-95 ITAA 1997) (Stapleton v FCT 89 ATC 4818; FCT v Grant [1991] FCA 336).

Work in progress is not normally transferred with the reconstituted partnership acting as agent to collect the work in progress on behalf of the original partnership under the Partnership Reconstitution Deed.

For GST, supplies occur between the partners under the aggregate approach, but also separately for the original partnership to the reconstituted partnership as a separate entity independent of the partners under the entity approach (sec. 184-5 GSTA 1999; sec. 195 GSTA 1999 definition of ‘entity’; GSTR 2003/13 at [27] - [28]).

Generally, the supply of the partnership interest is a financial supply by the partnership to the partner and between the partners which is not subject to GST (GSTR 2003/13 at [55] and [174]).

Concurrently, the supply of the partnership interest is a taxable supply by the original partnership to the reconstituted partnership under the entity approach, which may be a GST-free supply of a going concern (GSTR 2003/13 at [124]).

These tax consequences should be addressed in the Partnership Reconstitution Deed for a tax law partnership or a general law partnership without a partnership reconstitution power.

A general law partnership may be reconstituted without the tax consequences associated with reconstituting a tax law partnership, a joint venture or co-ownership.

The FCT accepts that the reconstitution of a general law partnership (but not a tax law partnership) is the continuation of the partnership, so does not have any income tax, CGT or GST consequences, other than for any retiring partner. (GSTR 2003/13 at [166] & [167]).

Subject to any agreement between the members, any change in the composition of the members of a general law partnership (whether or not augmented by new members) dissolves the original partnership and creates a new partnership that is legally distinct from the original partnership (Div. 4 PAV 1958; SJ Mackie P/L v Dalziell Medical Practice P/L [1989] 2 Qd R 87 at 90; Davis v Barlow (1881) 2 LR (NSW) 66 at 71; Re Kleiss; Ex parte McDonough (No. 2) (1969) 15 FLR 284 at 287).

If the Partnership Deed expressly provides for partnership continuity, there would be no dissolution of the partnership (Arcus v Richardson [1933] NSWLR 248; GSTR 2003/13 at [151] - [162]).

There is some uncertainty at general law regarding whether a general law partnership can be reconstituted in certain circumstances (GSTR 2003/13 at [151] - [162]).

It may be necessary to amend the Partnership Deed to include an express reconstitution power.

Where there is a continuing partnership, the FCT accepts there is no dissolution of the partnership where (GSTR 2003/13 at [168]; GSTR 2004/6 at [225]):

  1. the partnership is a general law partnership;
  2. at least one of the partners is common to the partnership before and after reconstitution;
  3. the partnership agreement included an express or implied partnership continuity clause;
  4. substantially all of the partnership assets remain with the continuing partnership; and
  5. the nature of the enterprise, the client or customer base and the business name or name of the firm remains unchanged.

Under the aggregate approach, there being no dissolution of the general law partnership means:

  1. the reconstituted partnership retains its tax file number, Australian business number, pay-as-you-go withholding and GST registration;
  2. the reconstituted partnership lodges only one tax return for the whole income year;
  3. there is no transaction with taxation consequences for trading stock (sec. 70-100 ITAA 1997), depreciable assets (sec. 40-340(3) ITAA 1997) or work in progress (sec. 15-50 ITAA 1997 and sec 25-95 ITAA 1997);
  4. there is no supply or acquisition from the old partnership to the reconstituted partnership for GST purposes, so there is no need to make a going concern election (GSTR 2003/13 at [124] & [172]); and
  5. the supply of the partnership interest between the partners is a financial supply not subject to GST (GSTR 2003/13 at [174]).

https://www.ato.gov.au/business/changing,-selling-or-closing-your-business/in-detail/changing-the-makeup-of-a-partnership/

Duty Treatment

Contrary to the approach of the CSRV, the reconstitution of a general law partnership does not have duty consequences.

Duty is levied on the ‘dutiable value’ (i.e. greater of ‘consideration’ or ‘unencumbered value’: sec. 20 DAV 2000) of ‘dutiable property’ (i.e. ‘an estate in fee simple’ in Victorian land: sec. 10(1)(a) DAV 2000) that is the subject of a dutiable transaction (i.e. a ‘change in beneficial ownership’: sec. 7(1)(vi) DAV 2000) (sec. 11 DAV 2000).

The CSRV considered the reconstitution of a general law partnership constituted a fractional dutiable change in beneficial ownership under the aggregate approach:

ABC Pty Ltd, as bare trustee and nominee of the Hotel Partnership, owns and manages a hotel in Melbourne. The deed establishing the Hotel Partnership shows that the capital of the partnership is held as to 50 per cent by D Pty Ltd, 30 per cent by E Pty Ltd and 20 per cent by F Pty Ltd. The deed also provides that the manager, being ABC Pty Ltd, holds the property of the partnership in its name in trust for the partners as an entirety and will deal with that property as directed by them. Under the deed, the partners have undertaken not to attempt to obtain a partition and/or separate legal title to their interest in the partnership property.
Due to a realignment of business interests, D Pty Ltd wishes to leave the partnership and offers to sell its 50 per cent interest to either one or both of the remaining partners. As neither E Pty Ltd nor F Pty Ltd has the financial resources to purchase the interest, all three parties agree for the interest to be sold to a third party, Z Pty Ltd. Consequently, an agreement to sell a partnership interest is entered into between D Pty and Z Pty Ltd. Upon completion of the agreement, there is an assignment of the partnership interest to Z Pty Ltd.
As the partners have an undivided equitable/beneficial interest in each and every asset comprising the partnership including the hotel, the assignment of the partnership interest to Z Pty Ltd gives rise to a liability to duty as either a transfer of an equitable interest in land in Victoria or a transaction that results in a change in the beneficial ownership of such land.
Duty payable on the assignment of the partnership interest is calculated by reference to the greater of the consideration paid for the assignment and the unencumbered value of a 50 per cent interest in the hotel.

https://www.sro.vic.gov.au/changes-beneficial-ownership-property-without-changing-legal-ownership

It was unclear whether:

  1. the ‘equitable interest’ of a general law partner in the partnership and ‘beneficial interest’ in the surplus of partnership assets upon dissolution of the partnership was 'dutiable property' or a 'dutiable transaction' (sec. 7(4) DAV 2000; CSR (SA) v Cyril Henschke P/L [2010] HCA 43 at [28]; R. Speed, ‘Beneficial Ownership’ (1997) 3 AT Rev, 34); and
  2. a reconstitution (as opposed to a dissolution) of a partnership constituted a dutiable transaction transfer of the equitable choses in action in the partnership (cf CSR (SA) v Cyril Henschke P/L [2010] HCA 43 at [25] - [26]).

On 20 December 2017, the Victorian Court of Appeal held that the reconstitution of a general law partnership did not have duty consequences because (CSR (Vic) v Danvest P/L [2017] VSCA 382; [2017] VSC 125):

  1. the interest of the partner is a presently existing equitable chose in action, but prior to dissolution, is not a proprietary interest ‘in’ the assets of the partnership, so is not a dutiable property 'estate in fee simple' (at [2], [5], [83] and [164] - [165]); and
  2. the acquisition of the equitable chose in action did not effect any change in the beneficial ownership 'equitable interest in' the partnership assets (at [83] and [155]).

The effect of a reconstitution clause did not arise in the matter (CSR (SA) v Cyril Henschke P/L [2010] HCA 43).

Reconstituting a general law partnership (e.g. of trusts or companies) without tax or duty consequences may encourage the establishment of landholding general law partnerships in Victoria.