When it comes to tax treatment, not all alternative investments are created equal

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Over the last few years, investor appetites for alternative investments have been sharpened as a result of market uncertainty, market volatility and increasing inflation. In a market where stock prices disappoint and interest rates remain relatively low, alternative investments can provide an opportunity to boost returns, and diversify investment portfolios. However, investors should be mindful of the different tax treatment of various alternative investments.

According to the CFA Institute, alternative investments often share many of the following characteristics:

• Narrow specialization of the investment managers
• Relatively low correlation of returns with those of traditional investments
• Less regulation and less transparency than traditional investments
• Limited historical risk and return data
• Unique legal and tax considerations
• Higher fees, often including performance or incentive fees
• Concentrated portfolios
• Restrictions on redemptions

Alternative investments can be divided into two main groups: private assets such as private equity, private debt, infrastructure, and private real estate; and public hedge funds.

But accessing private assets is more complex than accessing traditional investments, such as public stocks and bonds. Investors can access alternative investments through investment in a private equity fund, direct investment into a company or project such as infrastructure or real estate, or co-investment into a portfolio company belonging to a fund.

In Canada, residents are taxed on their worldwide income and tax rates depend on the type of income, the source of income, and which person receives the income. (For the purposes of the Income Tax Act, a person is an individual, a corporation, and a trust). Income from alternative investment funds is taxed according to the legal structures of the investment, primarily limited partnerships, unit trusts, and corporations.

Investors in a corporation, a limited partnership and in a trust (although there may be some uncertainty here) have liability limited to the value of their investment. Under a general partnership, all of the partners share in the risk and reward of the partnership activities, and the liabilities of all partners are unlimited.

Many alternative investments, such as hedge and private equity funds, use a partnership structure with a general partner who manages the business and limited partners (investors) who own fractional interests in the partnership.

Here’s how different legal structures affect taxation.

An alternative investment fund that is set up as a partnership is generally fiscally transparent for Canadian tax purposes, which means that income or losses flow through to the partner, and income from a partnership retains its character in the hands of the partner. For example, regarding business income or dividends, the partner (taxpayer) includes the income or the losses in their tax return regardless of the actual distributions from the partnership.

Distributions from the partnership are not considered income to the recipient, but rather are an adjustment to the cost base (ACB) of the partnership interest. It’s mandatory that the partnership calculate the ACB of each partner, and it’s important that each member keeps track of their ACB annually, especially if they dispose of their partnership interest, which will allow them to calculate any capital gains or losses.

Basically, the ACB is calculated as follows:

• Contribution of capital and/or original cost of unit
• Add income from all previous fiscal periods
• Subtract partner withdrawals
• Subtract losses of previous fiscal period

An alternative investment fund that is set up as a Canadian-resident trust is treated as a taxpayer. However, in computing its income, it is generally entitled to deduct that portion of its income that is payable in that year to its investors, who are required to include such amounts in income.

An alternative investment fund that is a Canadian corporation is treated as a taxpayer and pays tax on its taxable income.

Whether it’s income which flows from a partnership to a partner, or income distributed from a trust or a corporation to a unit or a shareholder, in Canada, interest and ordinary income (including foreign income) is taxed at the highest marginal rate for individuals, whereas capital gains are taxed at half of the highest marginal rate thanks to a 50 per cent inclusion rate. In 2022, an eligible dividend is taxed at 34.3 per cent in the hands of an Alberta resident, while it’s taxed at 40.1 per cent in Quebec. An ineligible dividend is taxed at 42.3 per cent in Alberta and 48.7 per cent in Quebec.

Dividends received by Canadian corporations are generally deductible in calculating the taxable income of the corporation.

Click here to view the highest tax rates, province by province, for different types of income for 2022.

For further details concerning a taxpayer’s particular situation, taxpayer should consult their advisor.

Funda Dilaver is a tax advisor, Family Wealth Consultant, member of Estate Planning Council of Canada, Canadian Tax Foundation, and Association de planification fiscale et financière.

PBY Capital Limited is registered as an exempt market dealer and an investment fund manager with Canadian provincial securities regulatory authorities, servicing family offices and their professionals. For more information, visit: www.pbycapital.com.

This story was created by Content Works, Postmedia’s commercial content division, on behalf of PBY Capital Limited. The opinions and information provided in this article are solely those of the writer and are not to be construed as personal, legal, accounting, taxation, or investment advice, or as an endorsement of any entity.