A Quarter Century in Partnerships
Peter E. McQuillan, FCA*
P RÉCIS
En 1971, la réforme fiscale a entraîné l’introduction de nouvelles notions et
de nombreux changements dans la Loi de l’impôt sur le revenu. La notion
de société de personnes est antérieure à la réforme fiscale, mais la Loi de
l’impôt sur le revenu antérieure à 1972 ne contenait que huit mentions
distinctes de la «société de personnes». Par conséquent, l’imposition des
sociétés de personnes était essentiellement une question de procédure
administrative. La mention la plus importante de la société de personnes
dans la Loi de l’impôt sur le revenu antérieure à 1972 figurait à l’ancien
alinéa 6(1)c) : «(…) doit être inclus dans le calcul du revenu d’un
contribuable pour une année d’imposition (…) le revenu que le contribuable
a tiré d’une société ou d’un syndicat pour l’année, qu’il l’ait touché ou non
durant l’année». Lorsque cette phrase apparemment simple a été reportée
dans la nouvelle Loi de l’impôt sur le revenu, avec application postérieure
au 31 décembre 1971, elle est devenue une sous-section entière, soit la
sous-section j. Cette sous-section, qui traitait des sociétés de personnes et
de leurs associés, s’étendait des articles 96 à 103 et prévoyait un nombre
impressionnant de règles et de règlements devant être pris en compte
attentivement pour le calcul du revenu à la section B.
Durant le quart de siècle depuis la réforme fiscale, le domaine des
sociétés de personnes n’a pas fait l’objet d’une révision approfondie. Le
ministère des Finances s’est concentré à contrer le transfert injustifié de
certains types de déductions aux associés bénéficiaires. Cette longue
bataille semble s’achever par suite de la présentation de nouvelles règles
portant sur les dettes avec recours limité. Il est temps d’examiner
certaines modifications législatives probantes visant à corriger nombre
des lacunes susmentionnées, par exemple un cadre simple pour la fusion
de sociétés de personnes; un transfert du surplus exonéré et du surplus
imposable; la reconnaissance des sociétés de personnes comme des
moyens appropriés de gels successoraux; l’élargissement de la notion de
papillon aux sociétés de personnes; l’élimination du terme société de
personnes de la définition de «bien étranger» lorsque ces sociétés de
personnes comportent uniquement des biens canadiens; et la correction
de certaines anomalies et lacunes au chapitre des roulements existants
des sociétés de personnes.
Au cours des dernières années, la notion de société à responsabilité
limitée (SRL) a pris naissance aux États-Unis : les SRL sont reconnues
* Of KPMG Peat Marwick Thorne, Toronto.
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dans environ quatre cinquièmes des lois de divers États sur les sociétés
de personnes. Pour l’application du droit des sociétés, une SRL offre la
protection de la responsabilité limitée dont peuvent se prévaloir les
sociétés par actions traditionnelles; dans le cadre de la fiscalité, elle offre
le traitement de transfert normalement accordé à une société de
personnes. Essentiellement, une SRL est une société de personnes
constituée en société. Il est vrai que les avantages d’une SRL peuvent être
comparés à ceux découlant de l’utilisation d’une société en commandite,
mais une société en commandite constitue un moyen plus encombrant
du point de vue de la loi et elle peut permettre à un créancier déterminé
et bien financé de lever le voile sur la responsabilité limitée. Aucun
examen du traitement fiscal des sociétés de personnes ne serait complet
sans l’étude attentive des avantages que comporte l’adoption de la
notion de SRL au Canada.
ABSTRACT
In 1971, tax reform introduced new concepts and many changes into the
Income Tax Act. The concept of partnership predated tax reform, but the
pre-1972 Income Tax Act contained a mere eight separate references to
“partnership.” The taxation of partnerships, therefore, was essentially a
matter of administrative procedure. The most important reference to
“partnership” in the pre-1972 Income Tax Act was found in old paragraph
6(1)(c), which stated that “a taxpayer’s income from a partnership or
syndicate for the year whether or not he has withdrawn it during the year
shall be included in computing the income of a taxpayer for a taxation
year.” When this seemingly straightforward sentence was carried into the
new Income Tax Act for application after December 31, 1971, it occupied
an entire subdivision, namely, subdivision j. That subdivision, which dealt
with partnerships and their members, extended from sections 96 to 103
and set out an imposing array of rules and regulations that had to be
carefully considered in the computation of income for division B.
In the quarter century since tax reform was introduced, the partnership
area has not undergone a thorough review. Finance’s focus has been to
attack the unwarranted flowthrough of certain types of deductions to the
receiving partners. This long war seems to be drawing to a close with the
introduction of the new rules regarding limited recourse debt. The time
has come to consider meaningful legislative changes to correct many of
the deficiencies outlined above—for example, a simple framework for
merging partnerships; a flowthrough of exempt surplus and taxable
surplus; recognition of partnerships as appropriate vehicles for estate
freezing; extension of the butterfly concept to partnerships; removal of
partnerships from the definition of “foreign property” when those
partnerships contain only Canadian assets; and correction of some of the
anomalies and deficiencies in the existing partnership rollovers.
In recent years, the concept of the limited liability corporation (LLC) has
emerged in the United States: approximately four-fifths of the partnership
acts of the various states now recognize LLCs. For corporate law
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purposes, an LLC offers the protection of limited liability available to the
classic limited corporation; for tax purposes, it offers the flowthrough
treatment ordinarily accorded to a partnership: the LLC is, in essence, an
incorporated partnership. It is true that the advantages of an LLC can be
approximated with the use of a limited partnership, but a limited
partnership is a more cumbersome vehicle at law and may permit the
lifting of the veil of limited liability by a well-financed and determined
creditor. No review of the tax treatment of partnerships would be
complete without a careful consideration of the merits of adopting the
concept of the LLC in Canada.
THE TAX TREATMENT OF PARTNERSHIPS: AN OVERVIEW
In Canada, as in many taxing jurisdictions, a partnership is generally not
regarded as a separate person, but as a relationship between or among
partners. Therefore, Canada generally adopts the lookthrough or “transparency” principle by taxing the income generated from the partnership’s
activities in the hands of the partners rather than at the partnership level.
While the partnership itself is not regarded as a taxable entity, the income
and losses of the partnership are calculated “as if ” the partnership were a
separate person. Certain exceptions to the transparency principle in Revenue Canada’s administrative treatment of partnerships are sometimes to
the advantage and sometimes to the disadvantage of the taxpayer.
The Income Tax Act1 does not define “partnership.” Although section
102 contains a definition of “Canadian partnership,” that definition presupposes the existence of a “partnership” and therefore gives little guidance
as to what is considered a partnership for Canadian tax purposes. The
definition of “Canadian partnership” requires that all the members be
resident in Canada. There is no requirement, however, that all the partners be Canadian residents throughout the year. There is also no
requirement that a Canadian partnership carry on all or any part of its
business in Canada, or even that it be organized under Canadian law. The
relevance of “Canadian partnership” is most apparent when one considers
the accessibility of various rollovers for partnerships.
Under Canadian law, the meaning of “partnership” is derived from the
common law and from the provincial legislation under which partnerships
are created. Partnership legislation is similar across the Canadian provinces; the exception is Quebec, where civil law, as opposed to common
law, applies. Generally speaking, a partnership is an aggregation of its
members whereby two or more persons carry on business in common
with a view to profit. There must be an intention to earn a profit in order
for Canadian courts to find that the parties are carrying on business through
a partnership. The intention to form a partnership can be expressed in a
1 RSC 1985, c. 1 (5th Supp.), as amended (herein referred to as “the Act”). Unless
otherwise stated, statutory references in this article are to the Act.
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written agreement or implied by the conduct of the parties. A partner can
deal only with his or her partnership interests and not with the underlying
partnership assets, because a partner is entitled only to his or her share of
the net proceeds of the partnership property on a winding up of the partnership. Revenue Canada’s administrative position as to what constitutes
a partnership is set out in Interpretation Bulletin IT -90.2
If a legal relationship is determined to be a partnership, it cannot, for
certain other taxation purposes, be regarded as another legal structure. In
no circumstances, therefore, will an enterprise that is at law organized as
a partnership be recharacterized for tax purposes as a corporation (as is
possible under US tax law). Conversely, Canada does not yet have “corporations” that may elect to be treated as flowthrough vehicles in the
manner of a partnership: there is no direct Canadian equivalent of the US
limited liability corporations.
REPORTING REQUIREMENTS OF A PARTNERSHIP
Because a partnership does not pay tax, it need not file a tax return. For
many years after tax reform in 1971, there was no prescribed form or
prescribed filing for partnerships. Surprisingly, and in contrast to the
experience in the United States, not until 1989, under regulation 229, was
a mandatory annual information return (T-5013) required to be filed by a
partnership. Certain partnerships are still exempt from filing, as per Information Circular 89-5R3 (for example, partnerships with five or fewer
members). Each member of a partnership with more than five members
that either carries on business in Canada at any time during its fiscal
period or meets the definition of a Canadian partnership is now required
to file the annual information return on behalf of the partnership. In
addition, a partnership must file supplementary information, including,
inter alia, the allocation of the partnership income among each of the
partners, the allocation of capital cost allowance, and the continuity of
capital cost allowance as well as the continuity of the adjusted cost base
of each of the partners. This information is also filed by the partnership
on behalf of all the partners; a copy is then given to each partner. The
partnership itself is given an identification number, and the partners file
their supplementary slips from the partnership along with their tax returns.
ROLLOVER PROVISIONS ADDED IN 1971
When tax reform dictated that a partnership was to compute its income as
if it were a separate person, and when the concept of the taxation of capital gains was intoduced, an interest in a partnership became a separate and
distinct capital property that could itself be subject to a capital gain or a
capital loss. Attendant upon this concept was the need to introduce rules
that would, in certain circumstances, allow assets to be transferred into or
out of a partnership without a realization of gain upon the transfer.
2 Interpretation
3 Information
Bulletin IT-90, “What Is a Partnership?” February 9, 1973.
Circular 89-5R, “Partnership Information Return,” June 21, 1991.
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Subsections 85(2) and 85(3) allow a partnership to transfer its assets
into a corporation on a tax-deferred basis in exchange for shares of the
transferee corporation, and then allow the partnership to wind up and to
distribute to each of the members of the partnership the shares that had
been taken back by the partnership. Ordinarily, such a transfer of assets
from a partnership to a corporation (with a subsequent windup of the
partnership) could ordinarily be achieved on a tax-deferred basis. More
important, subsection 97(2) allows the transfer of assets from a partner to
the partnership on a tax-deferred basis. This is the partnership equivalent
of the corporate rollover in subsection 85(1). In turn, subsection 98(3)
allows the partnership to wind up and to distribute, pro rata, its assets to
each partner on a tax-deferred basis.
Subsection 98(5) permits one partner to buy out his or her other partners in such a manner that the surviving partner will have no immediate
realization of his investment in the partnership; all of the former partners
(the vending partners) will be deemed to have sold a capital interest in
the partnership to the buying partner. Subsection 98(6) provides a continuation of a predecessor partnership by a new partnership when one or
more partners withdrew from a predecessor partnership. Under the more
common interpretation of subsection 98(6) and the administrative practice of Revenue Canada, this is the rollover that ensures a continuity of
life to a predecessor Canadian partnership when the partnership agreement is silent, or even if it specifically provides for termination of the
partnership on the death or withdrawal of one or more partners. By and
large, these rollover provisions achieve the same results for partners and
partnerships that are available to corporations and their shareholders in
subdivision h of the Act.
With one major exception, the partnership rollovers have remained
substantially unchanged since their introduction in 1971. Technical anomalies have been corrected, and minor changes have been made to provide
for certain transitory concepts (for example, the $100,000 lifetime capital
gains exemption). However, no thorough review of these rollovers has
been undertaken with a view to a complete technical amendment, and
several necessary rollovers that would more consistently treat partnerships as favourably as corporations have not been added. This review is
long overdue. The infamous MacEachen budget of November 12, 1981
contained a number of proposals that would have materially altered the
conceptual application and availability of the partnership rollovers. These
proposals significantly paralleled the proposals for changes in the corporate rollovers. Fortunately, the proposals were never implemented.
The one major exception occurred on December 4, 1985, when the
then minister of finance attacked the “Little Egypt” bump. It was recognized that the opportunity to bump inventory and depreciable capital
property as well as non-depreciable capital property in the partnership
area (subsections 98(3) and (5)) was far more generous than the equivalent bump in the corporate area (subsection 88(1)). Taxpayers that might
otherwise have enjoyed only the corporate bump limited to non-depreciable
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capital property arranged their affairs so that they could enjoy the more
generous partnership bump even in a corporate context. The Department
of Finance, which faced the alternative of expanding the categories of
property that could be bumped in a corporate windup under section 88 or
limiting the property that could be bumped under a partnership windup,
was forced to act. Not surprisingly, Finance chose to narrow the bump in
the partnership area rather than expand the bump in the corporate area.
PRACTICAL ADDITIONS TO THE PARTNERSHIP
PROVISIONS: LEGISLATING ADMINISTRATIVE PRACTICE
In 1974, Finance added subsections 96(1.1) through 96(1.7) to the Act
and thereby introduced as legislation what had previously existed as a
commonsense administrative practice that allowed for the allocation of a
share of income to retired partners. The subsections were a welcome
addition to the Act, and by and large have remained significantly unaltered since their introduction. Similarly, sections 98.1 and 98.2 were added
to the Act in 1974; they codified the administrative practice that had built
up around the concept of a residual interest in a partnership. Because of
the relieving nature of both these changes, their application was made
retroactively effective to the 1972 taxation year.
FINANCE’S WAR OF ATTRITION AGAINST CERTAIN
PARTNERSHIPS
Perhaps the most significant attribute of partnerships is their flowthrough
nature, which clearly distinguishes a partnership from a corporation. If it
is anticipated that the investment by the taxpayer will yield losses in the
early stage of the investment, then a taxpayer may want to structure his
affairs to ensure that the loss flows through to him and can be used by
him against his other income during the period of those losses.
As early as 1971, the Department of Finance recognized that there
were certain kinds of property on which losses could not be flowed through
a partnership to the partners. As a result, regulations 1100(11) and 1100(17)
were introduced to ensure that capital cost allowance (CCA) could not be
claimed by the partnership on certain kinds of capital assets—namely,
rental properties and leasing properties—so as to create a net loss after
CCA that could be passed on to the partners.
Effective May 23, 1985, the rental property and leasing property regulations were expanded to limit CCA on certain fixed assets such as hotels
and yachts (regulations 1100(14.1), (14.2), (17.2), and (17.3)). The war
had begun! Taxpayers were desperate for tax shelters to be used to reduce
their other income. On December 16, 1987, Finance introduced paragraphs
96(1)(e.1) and (g) and moved its attack away from the regulations and to
the Act itself: in essence, it prevented the flowthrough of scientific research and experimental development (SR & ED) losses to passive members
of a partnership. Under subsection 96(1), SR & ED losses could not be allocated to a “specified member” of a partnership, defined in section 248
to include any member of a partnership who was a limited partner and
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any member of a partnership other than a member who was actively engaged in the activities of the partnership business. The war was escalating!
After years of attempting to create by administrative fiat a framework
of at-risk rules, a frustrated Department of Finance concluded that, for
greater certainty, the at-risk rules had to be legislated. On February 25,
1986, a formal body of at-risk rules was introduced into the Act in subsections 96(2.1) through 96(2.7). Though the provisions were somewhat
vague in their language, they were comprehensive, and their vague terms
were intended always to be construed in favour of the taxing authorities.
Interestingly, the at-risk rules initially were not to be applied to resource
expenditures made by a partnership. Aggressive conduct by tax-shelter
promoters made this exclusion short-lived. The aggressive interpretation
of the concept of seismic expenditures compelled Finance to act, and act
it did on June 17, 1987, when the at-risk rules were extended to the
resource areas with the introduction of new section 66.8.
Aggressive promoters were still looking for a loophole that could be
used in a partnership context, and they turned their attention to accrued
but unrealized losses dammed up in foreign partnerships. Canadian taxpayers could purchase an interest in the foreign partnership before those
accrued losses were realized, and then be on hand at the end of the fiscal
period of the partnership when the accrued losses were recognized in the
partnership accounts. The recognized losses would then be allocated to
the partners, including the Canadian partners who had bought their partnership interest months or days in advance of the loss recognition. In
1994 (but retroactive to December 21, 1992), subsection 96(8) was introduced; the subsection imposed a further limitation on the flowthrough of
that type of loss to Canadian partners. Subsection 96(8) provides that,
when a Canadian taxpayer acquires an interest in a foreign partnership
that owns property with a fair market value less than its cost, the cost of
inventory and of capital property and the capital cost of depreciable property of that partnership will be deemed to be the lesser of the fair market
value at that time and its cost or capital cost otherwise determined. Thus
Finance legislated against Canadians purchasing the “pregnant losses” of
a foreign partnership.
In December 1994, with the introduction of the concept of “limited
recourse financing,” the minister of finance struck what may ultimately
be the final blow against the use of partnerships to flow through undeserved tax deductions to investors. The result has been that, in addition to
the perceived abusive arrangements, even certain bona fide arrangements
may be attacked.
New subparagraph 53(2)(c)(i.3) of the Act will provide for a decrease
in the adjusted cost base of a taxpayer’s interest in a partnership to the
extent of any limited recourse indebtedness of the taxpayer that can reasonably be considered to have been used to acquire the partnership interest.
Paragraph 53(2)(c) is amended to exclude from its application partnership
interests that are tax-sheltered investments, consequential on the introduction of new section 143.2. That section provides for the reduction of
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the amount of certain expenditures of a taxpayer to the extent that a
“limited recourse amount” can reasonably be considered to relate to the
expenditure (for example, in respect of the taxpayer’s tax-sheltered investment). It seems that with this bodyguard of amendments Finance should
now be satisfied that there will be no flowthrough of net losses or deductions to investors in partnerships in any manner that offends the department.
OTHER AMENDMENTS TO THE PARTNERSHIP
PROVISIONS
In 1979, having recognized that taxpayers were using partnerships to
increase their access to the small business deduction, Finance amended
section 125 to introduce the concept of “specified partnership income,”
thereby rendering the first $200,000 of active business income flowing
through a partnership eligible for the small business deduction in the
hands of corporate partners. This philosophy was arguably extended a
little too far in 1988 with the addition of subsection 125(6.2):
Notwithstanding any other provision of this section, where a corporation is
a member of a partnership that was controlled, directly or indirectly in any
manner whatever, by one or more non-resident persons, by one or more
public corporations . . . or by any combination thereof at any time in its
fiscal period ending in a taxation year of the corporation, the income of the
partnership for that fiscal period from an active business carried on in
Canada shall, for the purposes of computing the specified partnership income of a corporation for the year, be deemed to be nil [emphasis added].
In May 1985, in an effort to stimulate the funding of smaller Canadiancontrolled private corporations, the federal government introduced a
number of financial intermediaries, which became eligible investments
for the tax-deferred plans (registered pension plans, deferred profit-sharing
plans, registered retirement savings plans, and registered retirement income funds). The May 1985 budget significantly increased the ability of
the tax-deferred plans to invest directly and/or indirectly in the debt and
equity securities of small businesses (especially private). The Act was
changed to allow direct investment in certain qualifying securities of
eligible corporations and indirect investment through new intermediaries
defined in the Act. The new intermediaries included qualified limited
partnerships (QLPs), small business investment corporations (SBICs), small
business investment limited partnerships ( SBILPs), and small business
investment trusts ( SBITs). Investment in SBICs, SBILPs, and SBIT s was
even rewarded by the expansion of the tax-deferred plans’ foreign property limit from 10 percent to 30 percent (on the basis of three dollars of
foreign property limit for each dollar invested). Unfortunately, the response to these new financial intermediaries has been lukewarm.
Although a partnership interest ordinarily could be rolled over to a
spouse in a tax-free transfer, when the adjusted cost base ( ACB) was
negative at the time of the transfer it would be set to nil and the transferor
would have a deemed capital gain equal to the amount of the negative
ACB. Paragraph 70(6)(d.1) was added in 1994 (retroactive to dispositions
made after January 15, 1987): the paragraph provides that, where the
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property transferred is an interest in a partnership, the taxpayer will be
treated, except for the purposes of paragraph 98(5)(g) of the Act, as not
having disposed of the interest immediately before his death, and the
transferee will be treated as having acquired the interest at its cost to the
taxpayer. So that the transferee will be in the same position as the taxpayer, any amount added or deducted by the taxpayer under subsection
53(1) or 53(2) in respect of the partnership interest will be similarly
added or deducted, as the case may be, in computing the transferee’s ACB
of the interest.
Subsection 100(2.1) was added on January 15, 1987. The subsection
provides that when an amalgamation occurs after that date, the new corporation formed on the amalgamation acquires a predecessor corporation’s
interest in a partnership. The predecessor is treated as having disposed of
its interest in the partnership to the new corporation immediately before
the amalgamation for proceeds of disposition equal to its ACB, and the
new corporation is treated as having acquired the interest immediately
after that time at a cost equal to the amount of such proceeds. As a result,
the predecessor corporation will be required to recognize a gain on disposition of any interest in the partnership that has a negative ACB. As a
result of this amendment, it is now necessary to calculate the ACB of any
partnership interest held by a corporation prior to any amalgamation. It is
very easy for a partnership interest to be positive for accounting purposes
but negative for tax purposes (since draws reduce ACB when made, but
accruing profits do not enter the ACB until the year-end of the partnership). Note that the application of subsection 100(2.1) is narrowed to
situations in which the new corporation formed on amalgamation acquires the interest in the partnership from the predecessor corporation to
which it was not related. Subsection 251(3.1) treats the new corporation
as related to any predecessor corporation to which it would have been
related immediately before the amalgamation if the new corporation had
been in existence at that time. Before the enactment of subsection 100(2.1),
it had been argued that (except for Quebec income tax purposes), when a
corporation holding a partnership interest with a negative ACB amalgamated, the ACB was set to nil in the amalgamated company without the
predecessor’s having to recognize the gain—obviously an anomalous and
undeserved result.
ELIMINATING THE TAX DEFERRAL ENJOYED BY
INDIVIDUALS IN A PARTNERSHIP
Individuals who have carried on business either as a proprietorship or as
a partnership have been able to defer the payment of tax on business
income by selecting a business year that ends before December 31. For
example, if an individual started a business in a partnership on February 1,
19-1, he could select as his first year-end January 31, 19-2. In his personal tax return for the calendar year ending December 31, 19-1, he
would have no income from this partnership business to report (or on
which to pay tax) for the period from January 1, 19-1 to December 31,
19-1. The income for the 11 months in 19-1 (from February 1, 19-1 to
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December 31, 19-1) would be recognized in the fiscal year ending January 31, 19-2, and reported in a personal return for the calendar year
ending December 31, 19-2. The February 27, 1995 budget proposes to
eliminate this deferral opportunity for all individuals (that is, proprietorships), professional corporations conducting the practice of the six
designated professions, and partnerships any member of which is a person described above. These taxpayers will be required to report their
income on a calendar-year basis for fiscal years beginning after 1994 (or,
alternatively, to retain a January year-end but to pay tax on their income
on a calendar-year basis).
Transitional relief is proposed that will provide for the inclusion of the
deferred income over a 10-year period: 5 percent in 1995, 10 percent in each
year from 1996 to 2003, and 15 percent in 2004. Individuals affected by
these rules will be able to file their personal tax returns on June 15 instead
of April 30, but will nevertheless be required to pay any balance of tax
owing by April 30. Finance has been clever enough and reasonable enough
to introduce this harsh provision with a generous 10-year transitional rule.
DEFICIENCIES IN THE CURRENT LAW
A Merger of Partnerships: The Missing Rollover
In both the corporate and the partnership sections of the Act, a number of
rollover provisions permit a reorganization to take place without triggering tax consequences. Unfortunately, since tax reform in 1971, no rollover
provision has dealt directly with a tax-free merger or combination of
partnerships. Since 1971 it has been generally necessary to use two separate partnership rollovers, neither of which at first glance appears to be
the most logical way to merge two partnerships. Taxpayers deserve a
partnership equivalent to the amalgamation provisions in section 87. It
should be possible simply to aggregate two partnerships on a tax-free
basis in such a manner that the combined partnership will have all the tax
attributes of the two predecessors.
The two partnership rollovers are found in subsections 97(2) and 98(3).
(Note that these two rollovers apply only to Canadian partnerships.) Merger
of a partnership by way of subsection 97(2) and subsection 98(3) requires
a careful navigation of the two provisions to ensure that problems do not
arise. For example, paragraph 13(7)(e) does not intervene when a nonarm’s-length partner transfers depreciable capital property. Careful and
sometimes artificial restucturing is required to ensure that
1) the half-year rule regarding the acquisition of depreciable capital
property does not intervene;
2) leasehold interests are not subjected to a longer than necessary period of amortization;
3) there are no traps in merging principal business real estate partnerships; and
4) the reserve accounts in paragraphs 20(1)(m) and (n) and the instalment sale reserve in paragraph 40(1)(a) are not unreasonably run off.
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Lack of Flowthrough of Exempt Surplus and Taxable
Surplus Pots Through a Domestic Partnership
Revenue Canada has indicated that where a Canadian partnership holds
shares of a foreign corporation that meets the definition of a foreign
affiliate, then the foreign corporation is a foreign affiliate of the partnership and not the partners. Revenue Canada argues that, for the purposes
of computing the income of the partners, the partnership owns the shares
of the foreign corporation. Therefore, in determining the relationship to
the foreign affiliate, the partnership is considered a separate person. If the
partnership holds an investment in a corporation that constitutes a foreign
affiliate of the partnership, and if that foreign affiliate is also a controlled
foreign affiliate of the partnership, the partnership will include in its
income its share of any foreign accrual property income, and it will retain
its character when allocated to the partners. However, Revenue Canada
takes the somewhat debatable position that, regardless of a partner’s direct or indirect ownership of a partnership that holds shares of a foreign
affiliate, “exempt surplus” and “taxable surplus” will not retain their character when passing through a partnership to Canadian partners that are
corporations, because the foreign corporation is not a foreign affiliate of
the Canadian corporate partners.
Tax Treaty Entitlement of Foreign Partnerships
When the applicable treaty recognizes that a foreign partnership is a “resident” of the other state because partnerships are treated in that state as
taxable entities, the partnership itself ordinarily would be entitled to treaty
benefit, according to the OECD model.4 In the light of section 6.2 of the
Income Tax Conventions Interpretations Act, 5 however, it appears that
Canada will view the foreign partnership as entitled to the tax treaty
benefits in respect of non-resident partners only if none of the partners is
resident in Canada.
If the treaty in question does not refer to a partnership as a person,
Canada will view each of the foreign partners as having received his
proportionate share of Canadian source income directly and will afford
the tax treaty benefits accordingly. If some or all of the partners of the
foreign partnership are residents of a third state, Canada will apply the
tax treaty with the country in which the partnership was established if the
foreign partnership is recognized as a person for the purposes of that
treaty. In any other case, the relevant treaty will be between Canada and
the country in which the partners themselves are resident.
If no treaty is in force with this third state, Canada, as the state of
source, will levy the full 25 percent withholding tax under part XIII of the
Act on any passive income paid to the partnership. If the foreign partnership were carrying on business in Canada, the partners resident in the
4 Organisation for Economic Co-operation and Development, Model Tax Convention on
Income and on Capital (Paris: OECD) (looseleaf ).
5 RSC 1985, c. I-4, as amended.
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third state would have to include the full amount of their pro rata share of
the income from business sourced in Canada and would not be able to
claim the deduction for treaty-protected income under paragraph 110(1)(f )
of the Act. Note that section 6.2 of the Income Tax Conventions Interpretations Act was added by Canada to ensure that the principles enunciated
in the United Kingdom in Padmore 6 were not extended to Canadian treaty
interpretation. The application of section 6.2 of the Income Tax Conventions Interpretations Act may be retroactive.
Allocation of a Partnership’s Income or Loss to Partners
Who Acquire or Dispose of Their Partnership Interest
During the Partnership’s Fiscal Year
Subsection 96(1) of the Act requires a partnership to calculate the income
or loss from any source for its fiscal period and to allocate such income
or loss to its partners. Administratively, Revenue Canada permits the allocation of income or loss to partners even if they have not been partners
throughout the fiscal period of the partnership. Thus, partners may leave
or enter a partnership part way through a year, and all partners, both
part-year partners and former partners, will be allowed an allocation of
income and expense. This administrative practice should be clarified in
the legislation. Furthermore, if one partner exits a partnership part way
through the year and another partner enters, it is important that there be
agreement between the two parties as to how income is to be reckoned for
allocation purposes for the part year. It is also important to remember that
income or loss reckoned on a tax basis may be significantly different
from the income or loss reckoned on an accounting basis: the agreement
should be clear as to exactly how income is to be reckoned. Similarly, it
is important to recognize that, in reckoning a partner’s ACB, drawings
made at any time during the year reduce the partner’s adjusted cost base,
while income earned is not allocated to the partner for inclusion in this
cost base until the end of the fiscal period. To the extent that an interest
in a partnership is being rolled over at any time other than the fiscal
period of the partnership, it is important to recognize that the ACB requires careful attention in establishing the values to be used in the election.
Participating and Shared Appreciation Debt Obligations:
Do They Constitute a Partnership Interest?
Until recently, both lenders and borrowers were able to use participating
debt instruments in such a manner as to optimize their tax positions. A
borrower who sought to deduct the fixed and variable financing charges
on an as-incurred basis would argue that there had been no disruption of
its principal business status. A lender, frequently a non-resident, would
argue that fixed and variable finance income was income (other than interest) not earned from carrying on business in Canada through a permanent establishment, and that it was deductible but not subject to withholding
tax or branch tax. Two amendments to the Act have affected the use of
6 Padmore
v. IR Commrs., [1989] BTC 221 (CA).
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participating debt instruments. Paragraph 20(1)(e) has been amended so
that, to the extent that an amount was previously deductible immediately
under old paragraph 20(1)(e), it is no longer deductible immediately but
must be amortized over the period referred to therein (frequently, evenly
over five years). This amendment may render these instruments decidedly
less attractive to the borrower. Paragraph 212(1)(b) has been amended to
render both fixed and variable participation payments subject to a withholding tax that does not escape under subparagraph 212(1)(b)(vii).
Revenue Canada has been prepared to rule on the tax nature of a debt
instrument that contains fixed and variable payments, but only when the
yield, both fixed and variable, offered by the instrument approximates a
reasonable return similar to that of straight debt. The debt instrument
should therefore be thoroughly analyzed to determine whether it includes
positive (as well as negative) covenants that in themselves constitute
continual management decision making, which, if exercised, could constitute partnership. Is the income participation calculated on gross revenues
or net revenues? (A net revenue participation has more of the attributes of
partnership.) Does the debt holder share in losses? In the loss year, is the
fixed interest still payable? Is it cumulative?
If the holder of the participating instrument is deemed to hold a partnership interest, it may, under subsection 206(1), be “foreign property” to
an exempt tax-deferred plan. In addition, the partnership may cease to be
a principal business partnership if one of the new partners is not itself a
principal business corporation.
Participating and shared appreciation debt obligations may be recharacterizable as a partnership interest.
The Interaction of Subsection 129(6) and Partnerships with
Corporate Partners: The Norco Development Case
The issue of the payment of amounts by a corporate partnership to one of
the corporations associated with the corporate partners was considered in
Norco Development Ltd. v. The Queen.7 Norco Development was a
corporate member of a partnership. It was associated with a corporation,
Noort Brothers Construction Limited, which was not a member of the
partnership. Noort loaned funds to the partnership at interest. The interest
received by Noort was treated by it as Canadian investment income.
Revenue Canada reassessed Noort and included the interest in its active
business income pursuant to subsection 129(6). The minister of revenue
argued and the court agreed that the payment of interest was in essence
made by the corporate partners to the recipient, and therefore within the
ambit of subsection 129(6). In support of this proposition, the minister
reviewed case law, which had the effect of piercing the partnership veil
and causing the payments of interest to be viewed as being from one
corporation to another. The effect of this decision may be far more
widespread than is apparent on the surface. In essence, the conclusion to
7 85
DTC 5213 (FCTD).
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be drawn from this case is that amounts paid to or by a partnership are to
be treated as if they were paid to or by the individual partners. However,
it is not yet completely clear how the Norco decision should be applied in
practice. In Norco, the facts were straightforward: all the members of the
partnership were associated with each other, and all were associated with
the corporation to which the interest was paid by the partnership. But
how will Norco be applied if a 30 percent minority corporate partner in a
partnership with no other corporate partner is associated with a corporation to which interest and/or rents are paid by the partnership? Is 0
percent of the interest and/or rent deemed by Norco to be active business
income pursuant to subsection 129(6)? If a 60 percent majority corporate
partner is associated with a corporation to which interest and/or rents are
paid by the partnership, then it seems that, pursuant to Norco, 100 percent
of the interest and/or rent would be deemed to be active business income
pursuant to subsection 129(6). In Norco, the minister of revenue argued
and the court agreed that the payments were in essence made by the
corporate partners to the recipient; it is therefore surprising when the
policy behind this decision is transposed to a partnership that has borrowed money from a specified non-resident. Consider the case of a
corporate partnership in which one of the corporate partners is a
foreign-controlled corporation that perhaps controls the partnership. If
the partnership itself borrows significantly from the parent company of
the foreign-controlled Canadian corporate partner, the rationale in Norco
seems to suggest that the interest-bearing indebtedness will be tested
against the thin capitalization provisions in subsection 18(4) as if the loan
had been made directly from the specified non-resident to its Canadian
subsidiary corporation.
Surprisingly, the rationale in Norco does not seem to be applied even
by Revenue Canada to this particular fact pattern. Revenue Canada has
commented several times at its round tables that such a loan from a
specified non-resident will not be subject to any test of thin capitalization, since a partnership itself is not directly subject to the thin
capitalization rules in subsection 18(4). While this particular interpretation may be lenient and readily accepted by taxpayers, it appears
inconsistent with the rationale established by Revenue Canada in Norco.
Permanent Establishments of Partnerships: Compliance
Issues for Partners
Certain partnership arrangements may cause partners to have permanent
establishments in more than one province. Prospective investors in partnerships should be aware of two important points:
1) A partnership must allocate its business income to each of the provinces or countries in which it operates through a permanent establishment.
Partners, both individuals and corporations, will become liable to income
tax and certain other provincial taxes in those provinces with permanent
establishments. The rules for recognition of income and the writing off of
various expenses may vary among the provinces.
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2) On a number of occasions, partnerships of professionals have asked
the Department of Finance to simplify the filing of personal tax returns
by the individual members. While Finance has been sympathetic to the
initial submissions, it has asked the various professions to determine
whether all of the members of the partnerships will be satisfied to simply
file and pay tax in their province of residence. Finance’s suggestion has
not been met with universal acceptance by members of the professions,
and as a result individual taxpayers (as well as corporations) remain subject to tax in each of the provinces in which they have a permanent
establishment.
Estate Freezes Using Partnerships
The concept of using a corporation to achieve a freeze in the value of an
individual’s estate is well understood. That understanding flows from a
continuing series of interpretation bulletins issued by Revenue Canada,
especially those dealing with the attributes of the share consideration that
must be taken back by the freezor in the classic estate freeze plan. The
rationale could easily be transposed to freezing in the context of a partnership interest, where the freezor was prepared to take back a capital
interest in a partnership that was entitled to a fixed priority return on the
freezor’s capital interest in the assets of the estate. For some reason,
Revenue Canada has been completely reluctant to allow the use of partnerships to achieve the kind of estate freeze attainable through a
corporation. Revenue Canada has on several occasions indicated that if a
party were to attempt an estate freeze using a partnership rather than a
corporation, the freeze might well be challenged under section 103 of the
Act on the basis that the allocation of income from the partnership was
not reasonable. It is unclear from a policy point of view why Revenue
Canada has been so reluctant to see partnerships used for estate freezing.
It is not obvious that the economic results and the attendant tax results
would be any less favourable to Revenue Canada because of the use of a
partnership rather than a corporation.
Immigration to Canada and Emigration from Canada
If a partnership is not carrying on business in Canada, but a member of
the partnership becomes a resident of Canada during the fiscal year of the
partnership, the individual will be taxed under part I for his or her share
of the income of the partnership for the entire fiscal period of the partnership that ends after the partner becomes a resident of Canada. While this
interpretation may be debatable, it is Revenue Canada’s view that there is
no basis for prorating the partnership income for periods before and after
the partner becomes a resident of Canada. The transfer to Canada does
not in itself cause a year-end in the partnership unless there are unusual
clauses in the partnership agreement. This could lead to a double taxation
of the income earned by the partner through the partnership during the
year of immigration to Canada. Conversely, when an individual ceases to
reside in Canada, under subsection 128.1(4) the individual will be deemed
to have disposed, at the time he ceases to reside in Canada, of each
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property owned by him, other than property that is taxable Canadian
property. Note that a partnership that has, at any time during the 12
months immediately preceding its disposition, a fair market value in excess of 50 percent of its assets by way of a Canadian resource property or
any other property used in carrying on a business in Canada will be
deemed to be taxable Canadian property. Therefore, the emigrating Canadian taxpayer who holds an interest in a partnership that does not qualify
as taxable Canadian property will be deemed to have disposed of that
capital property upon his ceasing to reside in Canada. It should be noted
that drawings at any time during the year reduce the partnership’s ACB.
Earnings accruing throughout the year do not enter into the reckoning of
the partnership’s ACB, but they do enter into the reckoning of the fair
market value of that partnership interest at the time of departure. The
departing resident will therefore be deemed to have disposed again and
be subject to a capital gain on the income that accrues in the partnership
prior to the emigration. This second element of inequity may be offset by
adjustments to the cost base of the non-Canadian partnership interest
suffered by the party when he first immigrated to Canada. In short, immigrants and emigrants who are partners in partnerships, particularly foreign
partnerships, may be subject to an element of double taxation.
Pushing Down Basis in a Partnership to the Underlying
Assets of the Partnership
An individual who purchases an interest in a partnership may have an
ACB in that partnership that is far in excess of his pro rata share of the
net cost amount of the net assets underlying the partnership interest. Is
there any way in which the taxpayer can cause his outside cost base to
become his cost base inside the partnership in the assets of the partnership? In Canada, this result can be achieved only with the greatest of
difficulty. The partnership must first be wound up under subsection 98(3).
The partner must then apply his excess cost base to bump up any
non-depreciable capital property; then all the partners must reconstitute
the partnership by transferring their assets back into the partnership. This
arrangement is extremely cumbersome, and the subsection 98(3) windup
may in fact be a taxable event to other members of the partnership. As a
result, a partner will seldom be able to push down his cost base to the
underlying assets of the partnership, even the non-depreciable capital assets of the partnership. There should be a simple election by which a
taxpayer can, in certain circumstances, transfer his excess outside ACB to
his net pro rata share of the cost amount of the partnership assets. Obviously, this election would be made only with respect to non-depreciable
capital property. This very analysis may also lead to the observation that
a partner who is going to sell his partnership interest in a taxable transaction may wish to rearrange his affairs so that the prospective incoming
partner purchases goodwill from the partnership and then transfers that
goodwill back into the partnership as his capital contribution, while the
outgoing partner accepts a complete allocation of the gain on the sale of
goodwill as a taxable event allocable only to the departing partner.
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Partnership Interests Remain Non-Qualified Investments
for Tax-Deferred Plans
It should be noted that the definition of “foreign property” in paragraph
206(1)(i) for the purposes of the deferred income plans indicates that a
partnership interest includes all partnership interests (unless prescribed).
This is so notwithstanding that every one of the assets within the partnership itself might otherwise be a qualifying investment if held outside the
partnership. This interpretation seems especially harsh, and prevents the
tax-deferred plans from making qualifying investments in Canadian partnerships that hold only Canadian real property.
Butterflying Assets from a Partnership
Beginning in the late 1970s, section 55 was expanded to include, indirectly, the divisive reorganization known as a butterfly. Throughout the
1980s, the butterfly was expanded by legislative changes and the continuing stream of administrative interpretations from Revenue Canada. In
February 1994, the butterfly provisions were significantly overhauled and
rendered far more difficult to comply with. Notwithstanding the narrowing of the provisions, Revenue Canada’s reluctance to allow assets to be
butterflied from a partnership is decidedly puzzling. It has been suggested that the butterfly provisions for partnerships could immediately be
added if Revenue Canada would merely agree that subsections 85(2) and
85(3) could be read in such a way that the transferee corporation referred
to therein was not one transferee corporation but more than one. If “transferee corporation” was construed in the plural, there would arise a complete
opportunity to use the two subsections to achieve a butterfly of assets
from a partnership using two or more corporations. In the mid-1970s,
Revenue Canada was prepared to say that “transfer corporation” could in
fact be read in the plural. Sometime around 1975, however, these informal interpretations were withdrawn and Revenue Canada indicated that
henceforth it was prepared to interpret the phrase only in the singular. As
a result, the opportunity to butterfly assets from a partnership seems to be
completely absent. Subsection 93(3) is not useful in butterflying assets
from a partnership because of its provision that each and every partner
must receive a pro rata undivided interest in each and every asset of the
partnership. Clearly, the time is long overdue for Revenue Canada to extend the butterfly reorganization to partnerships as well as to corporations.
Bumping Property Other Than Non-Depreciable Capital
Property: The Little Egypt Bump
On December 4, 1985, the Income Tax Act was amended in such a way
that the bump applicable on the windup of a partnership (subsections
98(3) and 98(5)) would most closely resemble the bump on the windup of
a subsidiary (subsection 88(1)). Under the old rule, it was possible on the
windup of a partnership to bump every kind of partnership property. Under the new rule, the bump was restricted in its application to nondepreciable capital property. However, it is important to remember that
while the old bump (the “Little Egypt” bump) is significantly precluded
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from future use, it is nevertheless still available and may apply after
December 4, 1985, when three conditions are met:
1) the member acquired the partnership interest before the relevant
date (or after the relevant date in a non-arm’s-length transfer);
2) the assets being bumped were owned by the partnership before the
relevant date; and
3) the partner is not a corporate partner that has undergone a change
of control since the relevant date.
Further, a portion of the same partner’s partnership interest may qualify
for the old bump, and another portion may qualify only for the new
bump. It is time that the old bump was given the continuing dignity that
it deserves: it should be properly incorporated into the Act as a separate
subparagraph or paragraph where it can be clearly read and understood. It
should not, as it now is, be relegated to fine print by way of notes to
subsection 98(3). This is an unreasonable attempt to bury the legitimate
and ongoing application of the old “Little Egypt” bump.
Subsection 96(1.1): Ongoing Problems and Deficiencies
As previously discussed, subsection 96(1.1) represented a codification of
administrative interpretations. Though useful, it leaves unanswered a
number of questions. Why, for example, is subsection 96(1.1) restricted
to those partnerships whose principal activity is the carrying on of business in Canada? Why the “in-Canada” requirement to give the commonsense results of subsection 96(1.1)? What interpretation is applied when
the partnership is in fact carrying on business principally outside Canada?
The income that is earned by the former partner from the partnership
pursuant to subsection 96(1.1) has many of the attributes of active
business income. Even though it may be paid periodically, it will be
taxable to the recipient only at the year-end of the partnership. Furthermore, if paid to a non-resident, it will constitute under subsection 96(1.6)
income earned by the non-resident from carrying on business in Canada.
Why, then, is this income not “earned income” that qualifies in determining whether the recipient is entitled to make RRSP contributions with
respect to this kind of income? Further, this kind of income is income
that arises quite naturally when one of the partners withdraws from a
two-person partnership and the remaining partner continues to allocate
income to the departing partner. Revenue Canada has indicated that it
will not interpret subsection 96(1.1) to allow the allocation of income
from a (present) proprietorship to a former partner. Is it possible for the
proprietorship to deduct such allocated amounts in reckoning the proprietorship income pursuant to paragraph 12(1)(g)? Clearly, such received
amounts would be taxable in the hands of the recipient. There should be
a provision for a former partnership that is now a proprietorship to make
such allocations, whereby both the payer and the payee agree that such
amounts are ordinary income and ordinary deductions rather than capital
payments.
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Problems with the Operation of Subsection 98(5)
Subsection 98(5) deals with the circumstances in which a partnership
business converges and is carried on as a proprietorship. While the subsection is easily read, there are a number of problems in its continuing
interpretation.
1) Consider, for example, the case in which company A and company
B are each partners in the AB partnership. Company A and company B
decide that they are going to amalgamate to form company AB . As a
result of their amalgamation, the two partners have converged into one
ongoing ownership of the economic enterprise, namely, company AB. Intuitively, one knows that subsection 98(5) should apply; technically,
however, the amalgamated corporation (deemed to be a new company for
income tax purposes) was a not a partner immediately before the partnership converged to form the proprietorship.
2) When all the partners simultaneously sell their partnership interests
to a willing buyer who was not a partner at the time of the sale, subsection 98(5) seems not to apply. Obviously, the problem can be avoided to
the extent that the buyer can, immediately prior to purchase, become a
partner in the partnership. Further, it is unclear what results do follow if
subsection 98(5) does not apply in the circumstances.
3) In the classic case in which partner A and partner B are carrying on
the AB partnership and partner A buys out partner B, in the absence of
any express agreement at the time of the purchase, which of them is
liable to pay tax on the stub period earnings of the partnership up to the
time that partner B sold his partnership interest? Is the stub period income taxable in the hands of partner B because he was a partner for part
of the year? Or is the stub period income taxable to partner A because he
has bought out the old partnership interest and carries on the partnership
business?
4) In many two-person partnerships, the deceased partner will be unable to transfer a continuing partnership interest to a beneficiary, either
because of a partnership agreement that triggers a sale to the surviving
partner (which will preclude the indefeasible vesting of the partnership
interest in the beneficiary) or because of rules of professional partnerships that prevent the non-professional beneficiary from being a partner
in a partnership carrying on a professional practice such as medicine, law,
or accounting. Subsection 98(5) appears to prevent the ongoing partner
from agreeing to purchase a package of assets from the beneficiaries
instead of purchasing a capital interest as anticipated in subsection 98(5).
5) Subsection 98(5) is not elective and applies automatically. Why
does it apply only in respect of a Canadian partnership? What are the
results in a similar fact pattern involving a non-Canadian partnership?
6) A problem may arise in the interaction of subsections 98(5) and
98(3). Consider the following. Two corporate partners carried on a business in partnership. After a number of years of partnership, it was decided
that one partner would buy out the other. The intention was to dissolve
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the partnership and distribute an undivided interest in each asset to each
of the partners (subsection 98(3)), and then to have the continuing partner
purchase the retiring partner’s interest in all the assets. It was hoped that
this would give the continuing partner a rollover as to one-half of the
assets, while the disposing partner would be taxed on the gains on the
assets that were sold. The problem arose in the interaction of subsections
98(5) and 98(3). Subsection 98(5) seems to say that if one of the partners
is going to continue the business, then the other partner will be denied
any form of rollover treatment and a gain will be realized at the partnership level. Subsection 98(4) provides that subsection 98(3) is not applicable
in any case in which subsection 98(5) is applicable. This seems to produce an unreasonable conflict in certain circumstances.
In summary, the rules of subsection 98(3), which might be beneficial
to all partners, are not available if one of the partners, within the
three-month period after the termination of the partnership, carries on the
business formerly carried on by the partnership and uses therein some of
the partnership property received by him in exchange for his partnership
interest, so that subsection 98(5) becomes applicable. This rule seems
particularly unfair when the partners, as part of the process of negotiating
the dissolution of the partnership, might have agreed that each would take
an undivided interest in each property and that subsection 98(3) should
apply. If one of the partners should subsequently commence to carry on
the business formerly carried on by the partnership (which may be a
common occurrence), then subsection 98(3) will not apply even though
an election under the subsection has been jointly made by all the parties.
The partner who breaches the agreement will be protected by the rules in
subsection 98(5).
More Confusion About the Transparent Nature of
a Partnership: The Robinson Trust Case
A recent decision of the Tax Court of Canada has cast some doubt on the
principle of transparency for partnerships in Canada. In Robinson Trust et
al. v. The Queen,8 the taxpayer trust was a limited partner of a partnership
that carried on an active business. The taxpayer trust wanted to apply the
exemption under subsection 122(2) of the Act so that not all of its income
would be subject to the top marginal rate of tax. For the exemption to
apply, the trust could not be carrying on an active business. Under the
normal transparency principle, because the partnership is carrying on an
active business the trust is also carrying on an active business and is
therefore unable to claim the exemption. The court, however, held that
the exemption applied. In particular, the court said that the trust’s interest
in the limited partnership did not cause it to carry on an active business
because the trust never exercised a management role in the partnership
and accordingly did not take part in the business of the partnership. Nonetheless, Revenue Canada has confirmed that notwithstanding the Robinson
8 93
DTC 1179 (TCC).
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Trust case, partnership assets used in an active business are considered to
be used by the partners in an active business.
When a Deceased Partner’s Capital Account Is in Deficit
When a deceased partner’s estate or heirs who do not acquire a partnership interest are required to make a payment to the partnership of which
the deceased was a member in an amount which, if it had been paid by
the partner while alive, would have increased the ACB of the partnership
interest pursuant to subparagraph 53(1)(e)(iv), the department allows the
ACB of the deceased partner’s partnership interest immediately prior to
the death to be increased by the amount so paid. This administrative
relief is found in Interpretation Bulletin IT-278 R2. 9 This concept warrants
legislative clarification.
Life Insurance Proceeds Received by a Partnership and Paid
Out to a Deceased Partner: A Possible Problem
Revenue Canada was asked to consider the treatment of life insurance
received by a partnership upon the death of one of the partners and to
address the issue of the treatment for tax purposes of the partners, including the deceased partner. Subparagraph 53(1)(e)(iii) of the Act provides
for an increase in the ACB of a partnership interest by the taxpayer’s
share of life insurance proceeds (net of the ACB of the policy). The question is whether and to what extent the net insurance proceeds increase the
ACB of the partnership if they arise when the net life insurance proceeds
are allocable solely to the deceased partner and are used to pay the estate
of the deceased for the partnership interest. It is Revenue Canada’s position that the subparagraph will apply only to the surviving partners because
the subparagraph refers to the taxpayer’s share of any proceeds of a life
insurance policy received by a partnership in consequence of the death of
any person insured under the policy. Because the adjustment can only
take place after the proceeds are received by the partnership, and because
the deceased partner is deemed to have disposed of the interest immediately before death and is no longer a partner at the time the proceeds are
received, no adjustment is possible with respect to the deceased’s former
interest in the partnership. Although the proceeds received by the partnership may be earmarked for use by the partnership to fund a payment to
the deceased’s estate, the estate does not have a right to any direct share
in the actual life insurance proceeds.
While I look forward to the changes that will come in the next 25 years
to the partnership provisions of the Income Tax Act, I doubt that I will be
called upon in 2020 to review those changes. Alas, perhaps the changes
will no longer be relevant to me!
9 Interpretation Bulletin IT-278R2, “Death of a Partner or of a Retired Partner,” September 16, 1994.
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