Buckwold and Kitunen, Canadian Income Taxation, 2014-2015 Ed.
CHAPTER 16
LIMITED PARTNERSHIPS AND JOINT VENTURES
Review Questions
1.
A limited partnership consists of two general classes of partners. Identify these classes,
and describe the rights and obligations of each.
2.
What can be done by a general partner to limit the extent of its obligations to the limited
partnership?
3.
“The tax treatment of limited partnership income and losses depends on the tax position
of each partner.” Explain.
4.
What key factors distinguish the limited partnership from the standard partnership?
5.
“A limited partnership provides broader access to sources of capital.” Is this statement
true? Explain.
6.
Why is there less risk for the passive investor when a business venture is organized as a
limited partnership, rather than a corporation?
7.
Why is it that the passive investor in a profitable business venture may receive a higher
rate of return if the venture is organized as a limited partnership, rather than a
corporation?
8.
What is a joint venture, and how is it different from a partnership?
9.
With respect to the following, how does the tax treatment applied to a joint venture differ
from that for a partnership?
(a)
Determination of capital cost allowance.
(b)
Active business income eligible for the small-business deduction.
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Solutions to Review Questions
R16-1. The two classes of partners required in a limited partnership structure are general
partners and limited partners. The general partner is fully liable for the obligations of the
partnership entity (i.e., beyond its proportionate ownership ratio) and is also responsible
for managing its business affairs. Limited partners, on the other hand, are responsible for
the partnership obligations only to the extent of their investment in the partnership entity
(similar to the limited liability aspect of a shareholder in a corporation). In addition, to
qualify as a limited partner, the investor must not take part in the management and control
of the partnership business. By definition, limited partners are passive investors.
[s.96(2.4), 96(2.2)]
R16-2. An investor who intends to be a general partner (and, therefore, is exposed to full risk)
can limit the extent of its financial risk by creating a separate corporation with a limited
amount of capital to act as the general partner. As the corporation has limited capital (i.e.,
the amount required for investment in the partnership) and is itself a limited liability entity,
it can only suffer losses to the extent of its net worth, even though it is liable for the
partnership's obligations.
R16-3. Similar to the standard partnership, the limited partnership is not a taxable entity. Instead
its net income or loss is allocated, for tax purposes, to the general and limited partners in
accordance with their profit sharing ratios. The income or loss allocated retains its source
and characteristic and is included in the partners’ income calculation in its original form.
The tax treatment of the income allocated is thus dependent on the nature of each partner
(i.e., whether they are individuals or corporations). For example, dividends allocated to an
individual partner are subject to a gross-up and dividend tax credit, but if allocated to a
corporate party would be treated as an intercorporate dividend excluded from taxable
income (but perhaps subject to a Part IV tax).
R16-4. The factors that distinguish a limited partnership from a standard partnership are as
follows: [s.96(2.4)]



Some partners in a limited partnership have limited liability. In a standard partnership
each partner is fully exposed to the entity's obligations.
Limited partnerships must have some partners who are not active in management
(i.e., are passive investors). The standard partnership does not have this requirement.
In a limited partnership, the losses allocated to the limited partners can only be used
by them to a maximum of their "at risk" amount. In a standard partnership, all losses
allocated are available for partner use.
R16-5. Yes, the statement is true when made in comparison to a standard partnership. In a
standard partnership, the unlimited liability feature tends to discourage the participation of
investors who are not active in management. In particular, it discourages the interest of a
large number of small passive investors from investing a small amount for a minor
partnership interest because the risk of unlimited liability is too high.
However, in a limited partnership, the requirement that limited partners be passive
investors in exchange for limited liability permits the partnership base to be divided into a
large number of small units. A small investor can, therefore, participate with a limited
amount of risk. This is similar to a corporation issuing shares to a number of smaller
investors except that the limited partnership has the added advantage of being able to
allocate its losses to the limited partners to create tax savings for them personally.
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R16-6. As a passive investor, an investment in a corporation or a limited partnership has limited
liability. Therefore, the amount that the investor can lose in each structure is finite and in
this sense each structure presents equal risk. However, the tax savings that can result
from suffering a loss in each structure is different. An investment loss from corporate
shares results in a capital loss of which only 1/2 is allowed for tax purposes at the time the
shares are disposed. In a limited partnership, the passive investor can usually deduct the
full amount of the loss, and the loss is recognized annually as the partnership allocates
business losses to the partners. For example, a taxpayer in a 45% tax bracket who lost
$10,000 in a share investment would suffer an after-tax loss of $7,750 ($10,000 - 45%
[1/2 of $10,000]), but in a limited partnership investment would lose only $5,500 ($10,000
- 45% of $10,000). Therefore, the downside risk of a limited partnership structure is less
for the passive investor than in a corporate structure.
R16-7. A passive investor in a profitable venture that is organized as a corporation distributes its
profits as dividends. When the passive investor is an individual, the dividend is taxable
and, therefore, two levels of tax occur (corporate and personal). Where the corporation is
a public company or a CCPC earning income in excess of the small business deduction
limit, some double taxation will occur. For example, from $1,000 of venture profits the
investor may receive a return of $540 as follows:
Corporate income
Tax @ 25%
Dividend distribution – Eligible
Tax @ 28%
Net to investor
$1,000
(250)
750
(210)
$ 540
However, under a limited partnership structure, the venture income is taxed only once at
the partner level. Therefore, $1,000 of venture profits may provide an after-tax return to
the investor of $550 ($1,000 - personal tax @ 45%). Because the limited partnership can
avoid double taxation for individual partners, greater after-tax returns can be achieved.
R16-8. A joint venture is an association of two or more entities for a given limited purpose without
the usual powers and responsibilities of a partnership. The primary feature that
distinguishes a joint venture from a partnership is the concept of limited purpose. A
partnership usually represents an ongoing business relationship whereas the joint venture
is formed for the purpose of completing a single transaction or activity of a limited
duration.
R16-9. In a partnership, the amount of capital cost allowance must be established by the
partnership and each partner is subject to that determination. In a joint venture, title to
property remains in the hands of the participants and, therefore, each participant can claim
all or a portion of the CCA permitted annually. This same treatment applies to other types
of discretionary items for tax purposes (e.g., reserves).
Active business income earned by a partnership is subject to a notional small business
deduction limit of $500,000 which must be shared by the corporate partners in their profit
sharing ratios. In a joint venture structure, no such limit applies. For example, if a joint
venture earns $700,000 of active business income, a 50% corporate joint venture
participant (CCPC) would be entitled to apply the small business deduction on its full
share of joint venture profits ($350,000) provided that it has not already used its limit from
its own other business activities.
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Key Concept Questions
QUESTION ONE
On March 1 of the current year, Mathew acquired a one percent interest in a partnership that
carries on a nursing home business in several provinces in Canada. Mathew paid $10,000 for
the partnership interest. The partnership reported a loss for the current year. Mathew was
allocated a business loss of $16,000 from the partnership. Income Tax Act reference: ITA
96(2.1), 111(1)(e).
Describe the tax implications of the loss for Mathew under the following two assumptions:
1) Mathew has a limited partnership interest, and
2) Mathew has a general partnership interest.
QUESTION TWO
Bill owns a 5% interest in a limited partnership. The adjusted cost base of his partnership
interest at the beginning of the current year was $40,000. For the current year Bill was
allocated $8,000 of capital gains and $22,000 of business income from the partnership. At the
end of the current year Bill had a loan from the partnership in the amount of $12,000.
Determine Bill’s at-risk amount at the end of the current year. Income Tax Act reference: ITA
96(2.2).
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Solutions to Key Concept Questions
KC 16-1
[ITA 96(2.1); 111(1)(e) – Limited partnership – at-risk rules]
1) If Mathew has a limited partnership interest then Mathew can claim the loss only to the
extent of his investment in the partnership, $10,000, being the amount at- risk of being
lost if the business venture of the partnership fails. The excess limited partnership loss,
$6,000, can be carried forward indefinitely and can only be claimed to the extent of the
at-risk amount from that same partnership. There is no carry back of limited partnership
losses. The at-risk rules do not apply to capital losses or farm losses incurred by the
partnership.
2) If Mathew has a general partnership interest then the entire $16,000 loss is deductible
against his other sources of income for the current year.
KC 16-2
[ITA 96(2.2) – Limited partnership – at-risk amount]
The at-risk amount is calculated at the end of a partnership’s fiscal period as follows:
ACB of the partnership interest (beginning of year)
Share of income for the current year:
Capital gains
Business income
Balance of loan received from the partnership
At-risk amount (end of current year)
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$40,000
$ 8,000
22,000
30,000
(12,000)
$58,000
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Problems
PROBLEM ONE
[ITA: 51(1),(2); 96(1); 121; 125(1)]
Georgio Enterprises is a limited partnership that operates a chain of family restaurants. The
partnership was profitable from its inception and is now generating consistent annual pre-tax
profits of $1,000,000.
The partnership includes 20 limited partners, each of whom contributed $60,000 when the
venture began. The limited partners, as a group, share 40% of Georgio’s annual profits. As the
partnership has not expanded for several years, most of the annual profits are distributed to the
partners within six months of the year end.
Most of the limited partners are individuals who are subject to a marginal personal tax rate of
45%.
Required:
1.
What is the annual after-tax return on investment for each limited partner?
2.
If Georgio Enterprises had been organized as a corporation, how would the rate of return
to the investors differ? Show calculations.
3.
Assume that Georgio Enterprises (as a limited partnership) made an annual cash
distribution sufficient only to cover each limited partner’s tax liability, and retained the
balance for expansion. How would the investors’ after-tax returns be affected by this,
considering that in order to realize their investment they may have to sell their partnership
interest for an increased value? Would the return on investment be different if Georgio
were a corporation and paid no dividends?
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Solution to P 16-1
1.
The annual after-tax return on investment for each limited partner is 18% calculated as
follows:
Partnership income
$1,000,000
Limited partners share (40%)
$400,000
Income allocated to each limited
partner (1/20 of $400,000)
Less tax @ 45%
After-tax return
$20,000
( 9,000)
$ 11,000
Return on investment:
$11,000
= 18%
$60,000
2.
If Georgio Enterprises had been organized as a corporation, the return to the investors
would vary depending on whether the entity was a public corporation or a CCPC.
As a public corporation, the return on investment would have been 18% as follows:
Corporate income
less corporate tax @ 25%
Available for dividend
$1,000,000
(250,000)
$750,000
Investors total share of dividend (40%)
$300,000
Each investor's dividend (1/20 of $300,000)
Less tax on eligible dividend (28%)
After-tax return
$15,000
(4,200)
$10,800
Return on investment:
$10,800
= 18%
$60,000
As a Canadian-controlled private corporation, the return on investment would have been
as follows:
Corporate income
Less tax
$500,000 @ 15%
$500,000 @ 25%
available dividend
$1,000,000
$ 75,000
125,000
Investors’ share of dividend (40%)
Dividends
($500,000 - $75,000)
($500,000 - $125,000)
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(200,000)
$800,000
$320,000
Eligible
Non-eligible
$425,000
$375,000
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Investors’ share of dividends (40%)
$150,000
Each investors dividend (1/20)
Less tax (eligible @ 28%; non-eligible @ 35%)
after-tax return
Return on investment:
(5,400 + $5,525)
$60,000
$7,500
(2,100)
$5,400
$170,000
$8,500
(2,975)
$5,525
= 18%
The after-tax returns of each structure are compared below:
Limited partnership
Public corporation
CCPC
18%
18%
18%
Note that a calculation of the CCPCs general rate income pool (GRIP) account is
necessary for an accurate allocation of dividends between eligible and non-eligible.
3.
If the limited partnership retains a portion of its profits for business expansion, the value of
the investor’s partnership interest would be higher as a result of this expanded capital
base in the partnership, compared to the value if all profits were distributed. However,
under a partnership structure, the adjusted cost base of the partnership interest would be
arbitrarily increased by the amount of profits allocated but retained (ACB is increased by
profits allocated and reduced by distributions to partners). Therefore, if the investor sells
the limited partnership interest at this higher value, a capital gain would not be realized on
the value attributed to the profits retained. Consequently, but for the timing of the cash
realization (immediate distribution versus a sale later), the investor's after-tax return on
investment would not be changed. [s.53(1)&(2)]
On the other hand, if the venture was a corporation and profits were retained forcing the
investors to realize their returns by a share sale, the result would not be comparable. The
value increase attributed to the profit retention would result in a capital gain to the investor
of which 1/2 would be taxable. In other words, the return is realized as a capital gain
rather than as a dividend. Consequently, the investor's after-tax return would be affected.
For example, if the investor is in a 45% tax bracket, a capital gain would result in a tax
cost of 22.5% (1/2 of 45%) whereas a dividend distribution may result in a tax cost of 28%
or 35% (net of the dividend tax credit--see Chapter 10). Alternatively, if the investor has
not used up his or her capital gain deduction and the corporation is a small business
corporation, the capital gain may be tax free whereas the realization by dividend would be
taxed at 35%.
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PROBLEM TWO
[ITA: 20(1)(a); 96(1) ]
A new business venture requires $600,000 of equity capital from passive investors in addition to
the $400,000 of capital that is being provided by the initiator of the project. The $600,000 will be
raised by selling 30 units for $20,000 each. The 30 unit holders will participate in 60% of the
venture’s profits.
It is anticipated that business operations will begin on October 1, 20X1.The entity will use a
December 31 year end. Investors must contribute their funds on October 1, 20X1. The equity
capital of $1,000,000 will be used as shown below.
Working capital
Equipment
Start-up costs, staff training, and opening advertising
Operating losses:
20X1 (for the three-month period)
20X2
$ 200,000
300,000
200,000
250,000
50,000
$1,000,000
The initiator is uncertain how to organize the new venture and is trying to decide between a
separate corporation that will issue shares, and a limited partnership.
Required:
Which type of entity will make it easier for the initiator to raise the $600,000 of equity capital
from passive investors? Explain, using a single investor as an example.
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Solution to P 16-2
In addition to the potential benefits that will accrue from the new venture's success, potential
investors are interested in limiting their liability, minimizing the cash required for the investment,
and minimizing the after-tax loss (or downside risk) if the venture should fail. As both the
corporate structure and the limited partnership structure provide limited liability the
attractiveness of one versus the other relates to the latter two items.
Corporate Structure:
To obtain one of the 30 investment units, the passive investor will be required to come up with a
cash contribution of $20,000. No cash recovery of this amount will occur until the venture is
profitable and begins paying taxable dividends. The venture will suffer losses in the first few
years but those losses will be locked into the corporation and provide no cash flow from tax
savings until new venture profits are achieved. If the venture fails and the shares are disposed
of for a full loss of $20,000, the after-tax loss will be $15,500 as follows (assumes ACL can be
used or it is an ABIL):
Cash invested (and lost)
less tax saving from capital
loss (45% x 1/2 of $20,000)
After-tax loss
$20,000
(4,500)
$15,500
Limited Partnership Structure:
Under this structure, invested funds will be used for working capital, equipment acquisition, start
up costs and initial losses from operations. These losses are allocated to the limited partners for
tax purposes creating tax savings in a short period of time.
The losses for tax purposes that will be allocated are as follows:
Period 1
(3 months)
Operating loss
Start-up costs
Capital cost allowance
(below)
Total losses for allocation
Year 2
$250,000
200,000
$ 50,000
0
7,500
58,500
$457,500
$108,500
Capital cost allowance - It is assumed that the equipment is class 8 (20% CCA rate). In the first
period only 1/2 of the normal CCA is available and this must be pro-rated for the
short year (3 months).
Period 1: CCA - $300,000 @ 20% = $60,000 x 1/2 x 3/12
Period 2: CCA - $300,000 - $7,500 = $292,500 @ 20%
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$7,500
$58,500
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The allocation of the above losses will create tax savings for each limited partnership unit as
follows:
Period 1
Year 2
Total losses allocated
$457,500
$108,500
Available to limited partners (60%)
$274,500
$ 65,100
Loss per unit holder (1/30)
$9,150
$2,170
Tax savings @ 45%
$4,118
$977
Therefore, within three months of the investment, the investor can reduce their taxes otherwise
payable by $4,118 and within 15 months by $977. The initial investment of $20,000 is reduced
to $14,905 ($20,000 – ($4,118 + $977)) in a relatively short period of time.
In addition, if further losses are sustained and the venture fails, the limited partner’s maximum
loss of $20,000 is allocated as a business loss (fully deductible). The after- tax loss (downside
risk) if this occurs is:
Total loss
less tax savings @ 45%
$20,000
(9,000)
$11,000
The two structures are compared below:
Limited
Partnership
Corporation
Cash required after 15 months
$14,905
$20,000
Downside risk
$11,000
$15,500
It is clear that the limited partnership will be more attractive to the passive investor.
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CASES
Contesso Travel Inns Ltd.
Contesso Travel Inns Ltd. is a successful Canadian-controlled private corporation that owns and
operates a small chain of eight hotels in western Canada. The hotels offer high-quality lodging
at economy rates and provide only limited services to their guests. Contesso has succeeded
because of its unique approach to the lodging industry and its strong hotel management
expertise. The company has designed and constructed all of its existing units—in fact, a sister
corporation owned by the same shareholders (Contesso Developments Ltd.) maintains a small
staff whose sole function is to develop new hotels. Contesso Developments has made a profit
on each of the eight hotels it has developed over the past five years.
Contesso’s success has been noticed in the hotel industry, and a number of similar hotels have
sprung up across the country. The executives of Contesso realize that a race is on and that a
number of other companies will be competing for the most suitable sites for expansion. They
estimate that within eight years, the number of remaining quality sites will decline considerably
as more hotels are developed across the country.
Contesso seriously considered going public and raising a large amount of capital to embark on
a major expansion program. However, it rejected this proposal because it would have had to
give up a significant percentage of its equity and because it could not project a realistic
expansion plan in view of the increasing competition. At the same time, the company cannot
expand rapidly while still owning each new hotel, as each unit requires more than $2,000,000 in
equity capital as well as mortgage financing.
Contesso, therefore, has decided to concentrate on its two strengths—hotel management and
hotel development—and to permit outside investors to own each unit. The expansion plan is as
follows:
•
•
•
•
Contesso will identify and secure the right to acquire suitable sites.
The equity requirement for each new hotel is approximately $2,000,000. This will be
obtained for each project by the issuing of 200 ownership units to private investors. Each
investor may acquire any number of the 200 units. Contesso will receive a fee for organizing
the investors and issuing the ownership units.
Contesso Developments will develop the hotels and assist with the acquisition of all
equipment. In addition, the company will arrange mortgage financing for a fee.
Each hotel will be managed by Contesso under a long-term contract (12 years) in exchange
for a fee of 5% of the hotel’s gross revenue.
Contesso’s executives are satisfied that this plan will result in rapid expansion and, as well,
provide their company with significant income from management fees and development profits.
Also, after the expansion program is complete, the company will be in a solid position to acquire
ownership of the hotels if the outside investors wish to sell. Each new hotel will be sold to a
different investor group in a different city, and the company executives are uncertain about
which organization structure to choose. Each new hotel could be organized as a separate
corporation, in which case 200 common shares would be issued; or each could be organized as
a limited partnership, in which case 200 limited partnership units would be issued.
Financial information relating to each expansion unit is provided in Exhibits I and II.
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Required:
Prepare an analysis of the financial information and advise Contesso which organization
structure will be most attractive to prospective investors for each of the hotel units.
EXHIBIT I
CONTESSO TRAVEL INNS
Financial Requirements and Cost Allocations
1. Project cost and financing
Cost:
Land, building, equipment, and start-up costs
Financing:
1st mortgage (35-year amortization),
interest at 12%
Investors’ contributions:
200 X $10,000
$4,500,000
$2,500,000
2,000,000
$4,500,000
2. Cost allocations
Land
Building
Furniture and equipment
Landscaping
Linens and supplies
Costs of arranging mortgage
Opening advertising and staff training
Agent’s fees for selling equity units
Expense of issuing units (prospectus, legal, etc.)
$ 400,000
2,600,000
500,000
50,000
90,000
70,000
290,000
350,000
150,000
$4,500,000
EXHIBIT II
CONTESSO TRAVEL INNS
Anticipated Operating Information
Year
Average room rate
Occupancy percentage
Gross revenue
Operating profit before debt
service and depreciation
1*
40
60%
$400,000*
2
42
63%
$900,000
3
44
66%
$1,100,000
4
46
70%
$1,200,000
200,000
400,000
480,000
520,000
* Note: The entity’s year end will be December 31. Information for year 1 represents a half-year operation
period. Also, the operating profits exclude any of the start-up cost allocations of $4,500,000.
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Solution to Case - Contesso Travel Inns Ltd.
This case requires students to determine net income for tax purposes using the rules
established in Chapter 4 and then apply the result to alternative organizational structures for the
proposed expansion program. To complete the analysis, assumptions must be made for the
corporate and investor tax rates, as well as a discount rate for present value calculations. The
assumed rates are indicated as they apply.
Project Income for Tax Purposes
Although the operating results for the first four years are provided, they must be converted into
the annual amounts for tax purposes. The required adjustments result from interest on the
mortgage plus the write-off of all or portions of the initial costs of $4,500,000. The income or
loss for tax purposes is summarized below:
Year
Operating profit before
debt service and
depreciation
Less:
Interest on mortgage
(note 1)
CCA (Note 2)
- building
- equipment
- linen
Landscaping (note 3)
Costs incurred to
arrange financing
and issue units
(note 4)
Opening costs
Total deductions
Income(loss) for tax
1
_______
2
_______
3
_______
4
_______
$200,000
$400,000
$480,000
$520,000
149,940
299,430
298,770
298,020
39,000
25,000
45,000
50,000
153,660
95,000
45,000
--
144,440
76,000
---
135,774
60,800
---
114,000
290,000
712,940
114,000
707,090
114,000
633,210
114,000
608,594
$(512,940)
$(307,090)
$(153,210)
$(88,594)
Note 1: The mortgage interest is based on a monthly payment amortized over 35 years on
$2,500,000. The first period represents only one-half a year as indicated in the question.
Note 2: The building is Class 1 - 6% (assumed building built after March 18, 2007 and placed in
a separate CCA class). In the first year, the 1/2 rule applies [Reg. 1100(2)]. In addition, because
it is a short year (6 months) additional pro-rating of 1/2 applies [Reg. 1100(3)], Year 1 CCA is:
$2,600,000 x 6% x 1/2 x 1/2 = $39,000
Equipment is class 8 - 20%. Year 1 CCA is: $500,000 x 20% x 1/2 x 1/2 = $25,000
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Linen is class 12 - 100% and the 1/2 rule for new acquisitions does not apply. However, it is
necessary to pro-rate the CCA in year 1 for the short year (1/2 year). Year 1 CCA is: $90,000
x 100% x 1/2 year = $45,000
Note 3: Landscaping is a capital item but is specifically allowed as a full deduction in the year
paid [s. 20(1)(aa)].
Note 4: Costs incurred to borrow money and issue shares or units are capital items but are
specifically permitted as a deduction over 5 years at 1/5 per year [s.20(1)(e)].
Cost of arranging mortgage
Fees for selling equity units
Expense of issuing units
$ 70,000
350,000
150,000
$570,000
Annual deduction (1/5)
$114,000
Limited Partnership Structure
Under this structure, the losses for tax purposes are allocated to each limited partner and can
be used to offset their other sources of income. This creates tax savings for each of the four
periods as follows (assuming each investor is subject to a tax rate of 45%) Initial investment per
unit holder:
$2,000,000
= $10,000
200
Tax savings per unit holder:
Total
Loss
Year 1
2
3
4
$
Losses per
unit holder
Tax
saving @45%
Present Value
512,940
307,090
153,210
88,594
$2,565
1,535
766
443
$1,154
691
345
199
$1,154
615
276
141
$1,061,834
$5,309
$2,389
$2,186*
*Assumes a discount rate of 12% and the tax savings in year 1 occur immediately.
Therefore, the net cash cost of the investment of $10,000 under a limited partnership structure
is $7,814 ($10,000 - $2,186).
Future profits allocated are subject to a tax rate of 45% for an individual investor.
If the anticipated earnings are not achieved and greater losses are incurred, the investor
receives further write-offs for tax purposes up to a maximum of $10,000, or $4,500 (45%) of tax
savings. Therefore, the maximum loss to the investor is $5,500 ($10,000 - tax savings of
$4,500). The tax savings will occur as soon as the losses are incurred. [s.96(2.1)]
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Corporate Structure
If a corporate structure is used, the annual losses in the first four years are locked into the
corporation and can only be used as future profits, if any, occur. Therefore, the investor's cash
cost of buying shares is actually $10,000 compared to $7,841 for a limited partnership unit.
Future profits of the venture are subject to the small business deduction on the first $500,000 of
annual profits (or $2,500 per investor). When these profits are distributed, no double taxation
occurs and the total tax for the corporation and the investor is 45%, the same as for the limited
partnership. However, profits over $500,000 (over $2,500 per investor) are subject to a higher
corporate tax rate (approximately 25% on the excess over $500,000) and consequently some
double taxation occurs on distribution to the shareholders. The total tax on these earnings
(corporation plus shareholder) is approximately 46% (on income taxed at 25%) compared to
only 45% under the limited partnership structure.
If the venture is unsuccessful, the investor can only recognize a loss when the shares are sold
or the company is legally bankrupt or fully insolvent. Such a loss would likely qualify as an
allowable business investment loss [s.39(1)(c)] and the maximum loss would be:
Actual loss
Tax saving
45% (1/2) ($10,000)
$10,000
(2,250)
$ 7,750
This can be compared to the maximum limited partnership loss of $5,500 (above) keeping in
mind that the limited partnership tax savings from the loss will occur much sooner. Therefore,
the spread between the two on a present value basis is even greater.
The above analysis indicates that the limited partnership structure will be more attractive to the
investors.
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CASE TWO
Realco*
Realco, a real estate developer, is proposing to obtain land and build a small mall that will
house five stores. The five stores that lease the property will be responsible for all operating
costs (maintenance, property taxes, utilities and repairs, and so on).The project will be
constructed in 20X1 on behalf of a group of investors and will cost $700,000, as follows:
Building
Land
Parking lot
Interest during construction period
Landscaping
Mortgage finder’s fee
Legal fees:
Land purchase
Mortgage documents
Investor offering
Appraisal fee for mortgage
Broker’s fee for finding investors
$430,000
120,000
40,000
30,000
20,000
6,000
4,000
2,000
6,000
4,000
38,000
$700,000
The maximum mortgage available on the proposed property is $450,000. The annual interest
rate will be 11%.The only security required for the mortgage is the property itself. Realco has
found 10 individuals who are each prepared to borrow $25,000 personally to invest. Its role in
the project is now simply to develop the property on behalf of the investors. The ownership
structure has yet to be determined. It is expected that the property will be rented beginning in
January 20X2 for 10 years at $75,000 per year and that the property will be sold to the tenants
at the end of the lease. The sale price will be based on the fair market value at that time. After
the property is sold, the ownership structure will be liquidated, with all proceeds going to the
investors.
Realco has asked you to prepare a report that analyzes alternative structures for holding the
property and recommends the best from a tax perspective. The investors are interested in
paying the minimum amount of tax over the life of the investment. Indicate in your report what
the maximum tax write-off would be in 20X1 and 20X2, as well as the possible ramifications if
one of the investors decides to dispose of his or her interest before the end of 10 years.
Required:
Prepare the report.
* Adapted, with permission, from the 1989 Uniform Final Examination © 1989 of the Canadian Institute of
Chartered Accountants, Toronto, Canada. Any changes in the original material are the sole responsibility
of the authors and have not been reviewed or endorsed by the CICA.
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Solution to Case Two – Realco
Similar to the previous case, students must first determine the tax treatment of certain costs
associated with the project and then determine their impact on alternative organization
structures. In addition, each investor will borrow the full amount of funds required for his or her
contribution to the venture and, therefore, incurs interest costs separate from the project. The
rate of interest on these loans may vary for each investor but is assumed to be 11%, similar to
the rate available on the mortgage.
It is important to recognize that Realco's role in the project is only that of a developer.
Presumably, Realco will profit from the sale of the raw land to the project, and from construction
fees, but will not participate as an owner in the completed rental property.
The total project will cost $700,000 and will be financed as follows:
1st mortgage (11%)
Investor contributions
$25,000 x 10 investors
$450,000
250,000
$700,000
The project will be completed by the end of 20X1. Part of the total costs of $700,000 includes
interest during the construction period. It is assumed that this interest relates to a separate
bridge financing loan during the construction period. Therefore, the mortgage funds and the
investor contributions are assumed to be received by the project at the end of 20X1 resulting in
no interest cost from those sources in 20X1.
There are three basic structures that can be used for the 10 investors:



Separate corporation
Partnership (standard or limited)
Co-ownership
The tax impact for a standard partnership and a limited partnership are similar and are,
therefore, reviewed together recognizing that the limited liability feature would be different. The
issue of limited liability has less importance in this case because of the nature of the project.
Normally, a rental property investment is less risky than an active business. Students should
recognize this when comparing this issue to the other tax issues under each structure.
An important issue in the case is that the project is considered to be a rental property.
Therefore, the available CCA is restricted to the net rental income with respect to the building. A
similar restriction applies to the parking lot under the leasing property rules [Reg. 1100 (15)].
These restrictions may apply differently under each alternative depending on where the CCA
must be applied (i.e., at the entity level or at the participant level). They also do not apply to a
corporation whose principal business is the leasing of property [Reg. 1100(12)].
In reviewing each structure the following concerns should be addressed:



what is the amount of deductions available and when will they occur?
how will annual rental profits be taxed when earned and when distributed to investors?
what are the tax implications at the end of 10 years when the property is sold and the
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
proceeds distributed to the investors?
How may an investor dispose of his or her interest before the project is liquidated if
the need arises?
Review of the Development Costs
The development costs are reviewed below and then summarized for the first two years (20X1
and 20X2).
Interest during construction period - Although interest is normally deductible, s.18(3.1) denies
the deduction of most expenses incurred during the period of construction. Therefore, the
$30,000 is capitalized and added to the building cost for tax purposes (even though part of the
interest may relate to the land).
Landscaping - This cost is also a capital item but is specifically permitted as a deduction
[s.20(1)(aa)]. The restriction under section 18(3.1) above does not apply to landscaping (by
exception) even though it relates to the construction period.
Mortgage finder’s fee - This also is a capital item but s.20(1)(e) specifically permits a deduction
for costs incurred to obtain financing. The cost can be deducted at the rate of 1/5 per year over
a five year period. This same rule also applies to the other costs associated with obtaining the
mortgage:
Legal fees for mortgage documents
Appraisal fee for mortgage
Legal fees (land purchase) - This is a capital item and is added to the land cost. Therefore, no
deduction occurs until the land is sold.
Legal fees (investor offering) - The cost incurred to issue shares, partnership units or syndicate
units (co-ownership) can be deducted [s. 20(1)(e)] at 1/5 of the cost per year (the same as the
financing costs). The same applies to the broker’s fee for finding the investors.
Building - The building qualifies as Class 1 with a CCA rate of 6% (assumed acquired after
March 18, 2007 and placed in a separate class). The depreciable amount is $460,000 (building
cost $430,000 + $30,000 interest during construction period).
Parking lot - This cost qualifies as a class 17 property with CCA at the rate of 8%.
The project deductions, excluding the CCA and the investor's individual interest costs, for 20X1
and 20X2 are as follows:
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20X1
Landscaping
Cost of issuing debt or units:
Mortgage finders fee
Legal
--mortgage documents
--investor offering
Appraisal fee
Broker--selling units
$10,000
20X2
--
$ 6,000
2,000
6,000
4,000
38,000
$56,000
Deduction 1/5 of $56,000
Mortgage interest (11% of
$450,000)
11,200
11,200
-
49,500
$21,200
$60,700
Co-ownership Structure
Under this structure, each investor will own directly a proportionate share of the property. As
such, each investor owns 1/10 of the land and completed building. Each investor is entitled to
claim all or a portion of the permitted CCA in any year separate from the other investors, which
provides greater flexibility for each investor.
A single investor's position for 20X1 and 20X2 using this structure is as follows:
20X1
Rental income
Project deductions (above)
Project income (loss)
Investors share (1/10)
Less interest on $25,000
loan @ 11%
Loss before CCA
CCA (limited to net rents)
Loss for tax purposes
20X2
$
0
(21,200)
$(21,200)
$75,000
(60,700)
$14,300
$(2,120)
$ 1,430
0
(2,120)
0
$(2,120)
(2,750)
(1,320)
0
$(1,320)
Notice that the net rental income (loss) before CCA includes the investor’s interest on his or her
loan of $25,000 used to fund the equity contribution. Consequently, the determination of net
rental income for purposes of applying the CCA restriction on rental property (building) and
leasing property (parking lot) is first reduced by the loan interest.
The co-ownership structure also provides the following:


Taxable rental income in the future (after CCA) will be taxed at the investor’s personal
rates.
After 10 years, when the property is sold, each investor will realize a recapture of CCA
and a capital gain for tax purposes.
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
If an investor decides to sell his or her 1/10 interest in the project, the property sold
would be land, building, and parking lot. This would be attractive to a purchaser as the
acquisition of this property would permit the new purchaser to claim CCA based on the
acquisition price at the time. This would not occur if the new purchaser acquired
shares in a corporation or a partnership interest.
Partnership/Limited partnership structure
Under this structure, each investor will acquire a partnership interest rather than directly owning
land and building as in the co-ownership structure. Capital cost allowance must be claimed at
the partnership level before an allocation is made to each partner. The amount of CCA is limited
to the net rental income of the partnership. Each investor's personal tax position in years 20X1
and 20X2 is as follows:
20X1
20X2
Rental income
Project deductions (above)
Partnership CCA:
Building 6% of $460,000 =
Parking lot 8% of $40,000
Total (limited to $14,300)
Investors share (1/10)
Less interest on $25,000 loan
Loss for tax purposes
$
$27,600
3,200
$30,800
0
(21,200)
(21,200)
$75,000
(60,700)
14,300
0
.
$(21,200)
$(2,120)
0
$(2,120)
(14,300)
$
0
$
0
(2,750)
$(2,750)
Notice that the 1/2 rule was not applied to the CCA in 20X2. It has been assumed that the
construction was completed in 20X1 and CCA could have been applied in 20X1 but for the
rental property restriction. As the one-half rule applies to the year of acquisition (20X1) it is not
applied in 20X2.
Also, notice that under this structure, the CCA has been deducted at the partnership level before
the allocation to investors. As a result, the investor can deduct, separately, the loan interest on
the $25,000 equity contribution achieving greater tax deductions than was permitted under the
co-ownership structure.
The partnership structure also provides the following:



Future profits from rentals will be taxed at the investor's personal rates because of the
partnership allocation.
When the property is sold by the partnership, a recapture and capital gain will occur. This
income is allocated to the partners and treated accordingly.
If the investor wishes to dispose of his or her interest before the project is sold, it will require
a sale of the partnership interest. As mentioned previously, this may be less attractive to the
potential purchaser because future CCA will remain unchanged.
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Corporation structure
Holding the real estate in a corporation affects two important items. First of all, any losses within
the corporation are locked into the corporation and remain as a carry-over for use against future
rental profits. And second, because the corporation's only activity will be the rental project, its
principal business is the leasing of property and consequently restrictions on CCA for rental
properties and leasing properties do not apply [Reg. 1100(12) and information bulletin IT-371paragraph 9]. This means that the corporation can claim CCA to create a loss from the rental
activity, but because there is no other income, the loss remains as a carry-over subject to the
ten year limit. Provided that taxable income will be achieved within ten years, which appears
likely in this case, it would be prudent to claim CCA early and create a loss carry-over as this
will result in faster deductions.
The "available-for-use" rules may deny the deduction of CCA in 20X1, depending on its
completion date. The calculations below assume the property is available for use by the end of
20X1. Their application would not change the corporation's taxable income position for 20X1
and 20X2 but may affect the carry-over position. The corporation and each investor's position
for 20X1 and 20X2 are as follows: [s.13(26)&(27)]
20X1
20X2
Rental income
Project deductions
CCA - building (1/2 in 20X1)
- parking lot (1/2 in 20X1)
Corporation loss
Investors position:
Dividends
Less interest on $25,000
Loss for tax purposes
$
0
(21,200)
(21,200)
(13,800)
(1,600)
$(36,600)
$0
0
$0
$ 75,000
( 60,700)
14,300
(26,772)
(3,072)
$(15,544)
$
0
(2,750)
$(2,750)
The corporate structure also provides the following:

When rental profits occur, corporate taxes will be applicable at the high corporate rate (44
2/3%. However, on distribution, a tax refund equal to 26 2/3% of the rental income occurs
and this together with the dividend tax credit for the individual investor will not create any
significant double taxation (see Chapter 13).

When the project is sold, the corporation will incur a recapture of CCA and a capital gain.
While the corporation is taxable on this income, the refund mechanism, the dividend tax
credit, and the tax-free capital dividend on the non-taxable portion of the capital gain, all
serve to eliminate any significant double taxation when the corporation is wound up. The
individuals will realize their investment from dividends.

A departure from the project before the 10 year expected wind-up date would require a sale
of shares. As indicated previously, this would be less attractive to a purchaser than
purchasing a direct 1/10 interest in the land and building.
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Conclusion
It is difficult to assess the best structure from a tax perspective without projecting the after-tax
cash flows over the life of the project. The partnership/limited partnership structure provides the
highest deductions for each investor in the first two years. However, if one excludes the
consideration of the possibility of having to sell a proportionate interest before the expected
liquidation date, the corporate structure appears to be preferable because:

The corporation results in a faster deduction of CCA. Because CCA can be claimed in the
early years, creating a loss carry-over, that carry-over can be used in full whenever rental
profits are generated. For example, if in year 6, after the start-up costs are used up and
interest expense has declined, there is a net rental income, the loss carry-over can be fully
utilized. In the other structures, any unused CCA can only be deducted at the normal CCA
rate of 6% on the building.

In addition to the above, each investor can fully deduct the interest cost on his or her
$25,000 loan.
Therefore, with the exception of the first year losses of $2,120 per investor, the corporation
provides the deductions at the fastest rate. This combined with the fact that income earned by
the corporation does not result in double taxation on distribution means that taxation under the
corporate structure results in the maximum delay of tax. This must be weighed against the other
factors--the preference of which may vary with each investor.
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