Taxation on Partnership —— Taxable or Not and How

Author | Min Liao

Shanghai Landing Law Offices

The capital market where funds play important role is a facilitator for the economic development. Tax policies on the partnership advance with times accordingly. This article will illustrate partners’ contribution to partnership, analyze tax treatments regarding partnership operation, as well as discuss tax policies on exit of privately offered funds, so that to clarify tax implications in relevant phases of investment.

I   Property Contribution by Partners

i   Property Contribution

What properties can be contributed to partnership? Is encumbered property contributable? According to Partnership Enterprise Law of China, cash, tangible goods, intellectual property, land use rights or other property rights are properties that partners of general partnership can contribute to the partnership. Service contribution is allowed. Except limited partners are prohibited to contribute service to limited partnerships, properties that limited partners can contribute to the limited partnership are the same as of the general partnerships. No specific provisions on contribution of encumbered property under the Partnership Enterprise Law of China, especially contribution of certain special encumbered properties such as ownership retained property and leased goods of financial leasing¹ mentioned in the Civil Code of China.  

In U.S., property that can be contributed to the partnerships are money, tangible goods, unpatented technical know-how, goodwill, patents, accounts receivable etc. Partners are permitted to contribute encumbered properties to the partnership.

ii   Contribution of Non-monetary Assets 

i)Taxation on property contribution

Shall the gain or loss be recognized when the partner contributes property to the partnership? The Chinese tax laws make no specific provisions. According to the Chinese tax laws and regulations, when the Chinese resident enterprise invests non-monetary assets, the gain derived therefrom shall be recognized and payment of tax can be deferred not exceeding 5 years. Since no detailed limitations on the “investment”, the tax deferral policy may be applied to the property contribution to partnership. Similarly, property contribution by the Chinese individual resident is recognized as a taxable transaction. It is unclear whether the same rational is applicable to the property contribution by partners. 

According to the U.S. tax laws, transfer of property to a partnership in exchange for an interest in the partnership is viewed as a business transaction that should not be impeded by the imposition of a tax. No gain or loss is recognized at time of the contribution. The precontribution of gain or loss should not be shifted to the other partners when the partnership subsequently disposes of the property. In certain situations, the recognition of gain or loss to the contributing partner will be deferred to subsequent disposal of the property. 

Under U.S. tax laws, a partner’s basis in her partnership interest is commonly referred to as the “outside basis” and the partnership’s basis in its assets is the “inside basis”. Each partner’s interest in the partnership is booked in partner’s capital account. The outside basis and inside basis will be adjusted to reflect partnerships business activities. When the partnership sells the contributed property, the precontribution gain or loss will be solely allocated to the contributing partner, while the gain or loss arose after the contribution will be allocated to each partner. The inside basis, and adjusted basis of asset for tax purpose and book value of the asset booked in the capital account will be adjusted accordingly.  

ii)Tax treatment on contribution of encumbered property 

It is discussible whether the encumbered property can be contributed to the partnership since no specific provisions available in Chinese tax laws. If contribution of encumbered property is allowed, can we infer ownership retained property and leased good of financial leasing are contributable?  

The doctrine holder of security in substance believes substantial economic function determines constitution of security, though it may break rule of numerus clausus, surpass parties’ will and thus expand scope of security rights. To manage doctrine of security in form and doctrine security in substance, the direct method is to apply provisions of “other contract with security function”² under the Civil Code of China. Let’s take ownership retention as an example. According to Mr. Lixin Yang, in goods trading transaction, the seller may place ownership retention as security on the goods. Though goods are physically transferred to the buyer in accordance with relevant laws and agreement of the parties, ownership of the goods will be transferred to the buyer, should the account payable have been fully paid by the buyer, or relevant conditions have been satisfied. Thus, contribution of encumbered property to the partnership may be feasible provided the contributing party has certain amounts of financial interests over the assets.  

According to U.S. tax laws, tax treatment on contribution of encumbered property is as below: 

Where a contributed property is encumbered by a recourse liability³, in case amount of allocated recourse liability is lower than adjusted basis of contributed property, to the extent a contributing partner is relief of liability, she is treated as having received a distribution of cash from the partnership, where outside basis should be adjusted. For example, a partner contributes an equipment encumbered by recourse mortgage of $ 3 million in exchange of 50% interest in the partnership. If the partnership assumes the mortgage, the partner is considered to bear risk of loss for $ 1.5 million. The partner is considered to have $1.5 million debt relief and is treated as receiving a $1.5 million cash distribution from the partnership. The portion of debt from which the contribution partner is relieved is allocated to the other partner, who is considered to contributed $1.5 million cash to the partnership. The outside basis of contributing partner is decreased $1.5 million and outside basis of the other partner is increased $1.5 million.   

Where a contributed property is encumbered by a nonrecourse liability⁴, when the adjusted basis of the contributing property is lower than the allocated liability, different tax policy is applied. For example, each of the two partners hold 50% of interest in the partnership. A partner contributes an equipment encumbered by nonrecourse mortgage of $400,000 with adjusted basis of $100,000. The $300,000 liability is solely allocated to the contributing partner and the remaining $100,000 will be allocated to the two partners. Therefore, the outside basis of the contributing partner is decreased $5,000 and outside basis of the other partner is increased $5,000.  

II  Partnership Passthrough Taxation 

i   Passthrough principle

How to tax on partnership? According to the Partnership Enterprise Law of China, partners shall pay income tax on production and business operation incomes and other incomes in accordance with relevant tax laws. Guofa [2000] No. 16 innovatively adopts rules of passthrough and stipulates tax on production and business operation incomes of Individual Industrial and Commercial Households (the “IICH”) shall be applied to tax on incomes of investors of partnership. 

What is partnership enterprise? According to the Partnership Enterprise Law of China, partnership enterprise refers to the general partnership enterprises and limited liability partnership enterprises which are established within China by natural persons, legal persons and other organizations in accordance with the law. What is the IICH? According to the Regulation on Individual Industrial and Commercial Households, individual industrial and commercial households refer to Chinese citizens who have business operation capacity engaging in industrial and commercial business operations and have been registered at the industrial and commercial administrative departments pursuant to the regulation. 

Since partnership and the IICH are different in respective of legal entity, organization structure, operation model and responsibility etc., it is discussible to apply tax rules of IICH to partners of partnership. 

  Chart I   Passthrough Taxation on Partnership

ii   Quality of Income and passthrough principle

Tax on partnership shall follow principle of taxing after allocation. In every tax year, the partnership computes taxable income by deducting cost, fee and loss from total income, and it allocates such income to partners as production and business operation income in accordance with Caishui [2008] No. 159. The partners are taxed as IICH. Under this method, all incomes are added together and taxed. It is discussible not to consider quality of each income when do the taxing.

For example, partnership is established for the sole purpose to implement equity incentives programs. Since the partnership doesn’t run normal business in substance, it is doubtful tax policies on equity incentives are not applicable due to choosing partnership as platform. This actually breaks passthrough principle. 

Another example is equity transfer income tax applied to individual partners. When partnership transfers equity of invested companies, the individual partners will pay high income tax if they are taxed as IICH, as individuals are entitled to apply 20% tax rate provided they directly hold equity of the invested companies. This means the partnership fails to follow passthrough principle. 

The third example is tax on dividend received by Chinese resident enterprise partner fails to be taxed according to the passthrough principle. In practice, the enterprise partner cannot enjoy tax exemption on dividend when the dividend is distributed by another Chinese resident enterprise.  

Thus, we may think different incomes to be taxed differently. For the incomes where certain tax policies are applicable, the partnership may not treat them as production and business operation incomes of IICH.  For details, please refer to the chart below:  

Chart II   Passthrough Taxation Based on Quality of the Income

III  Taxation on Privately offered Funds

i   Taxation on limited partners and loss carried back and carried over

Will the enterprise limited partners of privately offered funds be taxed as IICH? According to Guofa [2000] No. 16, the answer may be yes. However, Caishui [2008] No. 159 specifies the enterprise limited partners are taxed as enterprises. Question is Caishui [2008] No. 159 may trump Guofa [2000] No. 16.

Another issue is the loss that privately offered funds suffered cannot be carried back or carried forward in China⁵. Not like enterprises, loss of enterprises is allowed to be carried forward. Generally, where an enterprise incurs a loss in a tax year, the enterprise is allowed to carry the loss forward to subsequent years to be set-off against income from subsequent years, provided the loss carried forward does not exceed five years. Let’s take privately offered equity investment funds as an example. Because the funds comply with principle of taxing after allocation, profits of previous years cannot be used to offset against losses incurred in subsequent years as profitable projects exit earlier than projects in loss.

ii  Tax Policies for Venture Capital Funds

Venture capital enterprises who meet conditions set forth in the tax laws⁶ are entitled to enjoy certain tax benefits, though such policies may breach provisions of Guofa [2000] No. 16. The preferential tax treatments solve the problems that individual partners are not eligible to pay individual income tax at rate of 20% on equity transfer income. Further, qualified partnership venture capital funds (the “Venture Capital Funds”) can use certain amount of investment to deduct income allocated from the partnership under certain circumstances.   

i)Taxation on Equity Transfer and Dividend

Venture capital enterprise may choose accounting of single investment fund or accounting of annual income on a consolidated basis. Tax implications to individual partners on equity transfer income and dividend are as below:

ii)Income Deduction

From individual income tax perspective, if venture capital funds choose accounting of single investment fund, the equity transfer income is zero when the calculated balance of equity transfer is zero or below. Loss cannot be carried back or forward. Unrealized loss cannot be deducted as loss. In addition, in case the aforesaid venture capital fund satisfies conditions set forth in Caishui [2018] No. 55, the venture capital fund may deduct 70% of total investment amount from equity transfer income of a tax year allocated from the partnership. The deduction cannot be carried over.

On the other hand, the Venture Capital Funds can use certain amount of investment to deduct income allocated from the partnership under certain circumstances. The enterprise partners are entitled to enjoy preferential tax benefits that 70% of total investment amount will be used to deduct equity transfer income allocated from the partnership, provided the Venture Capital Funds invest eligible startup technology enterprises for two years. The deduction can be carried forward. Individual partners enjoy the same tax treatments as well.      

Many topics are open regarding the partnership taxation. Unlimited possibilities are there when the fund investments reach in a mature stage. 

Annotates：

¹“Rules Application under Doctrine of Security in Substance and Conflicts Reconciliation ”, Hongfei Xie.

²“Rules Application under Doctrine of Security in Substance and Conflicts Reconciliation ”, Hongfei Xie.

³Recourse liability means any partner bears the economic risk of loss of the liability. “Fundamentals of Partnership Taxation (6th Edition)”, Foundation Press.

⁴Non recourse liability means no partners bear the economic risk of loss of the liability. “Fundamentals of Partnership Taxation (6th Edition)”, Foundation Press.

⁵“Reconsideration of New Policy on Venture Capital Enterprise— Analysis of Industrial Practice and Data from Non Tax Perspective”, Ruiding Jie.

⁶Qualified venture capital enterprises refers to partnership venture capital enterprises (funds) who comply with Interim Measures for the Administration of Startup Investment Enterprises or Interim Measures for the Supervision and Administration of Privately Offered Investment Funds, complete funds filing and operate in accordance with relevant laws and regulations.    

About the Author

Min Liao

Partner at Shanghai Landing Law Offices

L.L.M in Taxation at Boston University, Certified Tax Advisor and Certified Enterprise Legal Council

Ms. Liao was an attorney of law in Shanghai Allbright Law Offices, and worked as deputy legal director and senior tax manager in share listing companies and a tax manager in a big four accounting firm.

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