Tax Planning
Using Partnerships
Robin MacKnight
Wilson Vukelich LLP
Thought for the Day
• Anything you can do with a
corporation, I can do better with a
partnership!
May 27, 2010 2010 Tax Law for Lawyers 2
Topics for Discussion
• Why use a partnership?
• Trends in the cases and practice
• Partnership basics and tax fictions
• Section 103 – the allocation issue
• Limited partnerships
• Tax shelters and tax shelter investments
• Estate planning with partnerships
• Reading tax opinions
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Why Use a Partnership?
• It’s not a corporation!!
• No statutory rules
• No statutory protections
• Flexibility – in governance and
changing member rights and
interests
• Conduit for tax purposes
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Advantages to a Partnership
• Rollovers:
• Real estate (Loyens)
• Allocate inherent tax liability to contributing partner
• Governance:
• No statutory minority protection
• Matter of contract
• Anonymity – minimal filing and disclosure requirement
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Advantages
• Compensation:
• Avoids employment issues
• Allows “self correction” based on
performance
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Advantages
• Flexibility:
• Easier to trace performance of
business units
• No solvency tests
• Allows “self correction” of relative
ownership to protect the business
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Disadvantages
• CRA skeptical of partnerships –
perceived to be a tax avoidance vehicle
• Skepticism based on application of
section 103
• Notwithstanding, there is increasing use
of partnerships and conduit vehicles
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What is a Partnership?
• Common law test
• Two or more persons
• Carrying on business
• In common
• With a view to profit
• Codified in provincial Partnership Act
• Artificial statutory creatures – limited
partnership, limited liability partnership
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The Concept of Business
• “Adventure in the nature of trade” is a business for tax purposes
• Does mere common ownership suffice?
• What commercial activity is required to meet the business threshold?
• Can you demonstrate a “common intention” among the purported partners?
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Common Law Tests
• “in common” – requires intention of the
parties to create a partnership
• Critical difference between partnership
and other vehicles
• CRA’s recent basis for attack –
177795 Canada Inc. 2007 TCC 569;
2009 FCA 19; leave to appeal to SCC
dismissed
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Common Law Tests
• Note that tax motivation is not a
common law test – but query whether
it could demonstrate intention?
• Tax motivation does not expressly
disqualify a partnership under either
partnership or tax rules
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Common Law Tests
• No requirement that partnership
agreement be in writing or be registered
• Consequently, many unwritten
commercial arrangements may
constitute a partnership under common
law
• Note that a limited partnership does not
exist until notice is registered
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May 27, 2010 Osgoode Hall Law School 2006 LLM 14
Trends in the Cases
• CCRA initially challenged existence of
partnership on basis no business
existed
• Recent cases demonstrate low
threshold for “business”
• New CCRA challenge – is business
carried on “in common”?
May 27, 2010 Osgoode Hall Law School 2006 LLM 15
Trends in the Cases
• Low threshold for demonstrating a business
• Continental Bank Leasing
• Gagnon
• Quaidoo
• But still distinct from hobbies or personal use
• Dahl
• Johnson
Tax Fictions of a Partnership
• Paragraph 96(1)(a) – partnership is a separate person
• (b) – separate fiscal year
• (c ) - each partnership activity is a separate source carried on by a separate person
• (d) – deductions claimable by partnership
• (f) – nature of the source of income flows through to partners
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Computation and Allocation of
Income
• Income computed as if partnership
were a separate person from partners
• Income/gain/loss computed by source
• Income allocation generally set out in
partnership agreement
• Partners recognize income for their tax
year in which partnership tax year ends
• Note 249.1 for partnership fiscal year
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Subsection 103(1)
“ Where the members of a partnership have
agreed to share, in a specified proportion, any
income or loss of the partnership from any
source … or any other amount in respect of
any activity of the partnership that is relevant to
the computation of income or taxable income
of any of the members thereof, and the
principal reason for the agreement may
reasonably be considered to be the reduction
or postponement of the tax that might
otherwise have been or become payable…
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“… the share of each member of the
partnership… is the amount that is
reasonable in the circumstances
including the proportions in which the
members have agreed to share profits
and losses of the partnership from other
sources or from sources in other places.”
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Subsection 103(1.1)
“Where two or more members of a
partnership who are not dealing with each
other at arm’s length agree to share any
income or loss of the partnership… and
the share of any such member … is not
reasonable in the circumstances having
regard to the capital invested or work
performed for the partnership by the
members thereof or such other factors as
may be relevant …
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“… that share shall, notwithstanding
any agreement, be deemed to be the
amount that is reasonable in the
circumstances.”
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Recent Cases
• XCO Investments 2005 TCC 655; aff’d
FCA 2007 FCA 53
• PennWest Petroleum 2007 TCC 190
• Krauss 2009 TCC 597
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Commercial Issues
Formation of limited partnership
• LP formed when a declaration filed
• Must there first be a valid partnership?
• Not a legal entity
• No restriction on business activities
(except LLPs – only professions can
use them)
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Commercial Issues
Liability Issues:
• No limits on liability of general partner
• Limited partner liable only
• in respect of the value of money and
other property the limited partner
contributes, or
• agrees to contribute
• as stated in the record of limited
partners
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Commercial Issues
Restrictions on Limited Partners:
• Cannot have limited partner’s name in firm name
• Cannot contribute services – only money and property
• Limited partner must be a passive investor and cannot participate in the control of the business
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Commercial Issues
What constitutes control on the part of a
limited partner?
• Haughton Graphics Ltd.v.Zivot and
Marshall
• Nordile Holdings Ltd.v. Breckenridge
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Limited Liability Partnerships• Recent amendments in Ontario havel
created “full shield” LLPs
• Problem – partners will have limited
liability – so notwithstanding they are
active in the business, they will be
subject to all the limited partnership rules
• Note 40(3.14) – prevents capital gain
when negative ACB arises? (see comfort
letter)
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Limited Partnership Losses
• Concept – losses deductible by a limited
partner in respect of a taxation year
cannot exceed the partner’s “at risk
amount” at the end of that year
• Such “excess” losses are limited
partnership losses
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Who is a Limited Partner?
Act deems a partner to be a limited
partner if:
• Liability is limited by operation of law
• Member is entitled to specified
benefit
• Certain agreements relevant
• 3 year rule (see Brown)
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Timing Issues
Deduction of losses restricted if
member is a limited partner “at
any time in the taxation year”
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Limited Partnership Losses
Losses which exceed the limited
partner’s at-risk amount are:
• Not deductible in computing taxable
income for the year; and
• Not included in computing the limited
partner’s non-capital losses for the
year
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Limited Partnership Losses
Excess losses of limited partners
are:
• Eligible for indefinite carry-forward
• Deductible if there is future income
or future additional capital
contributions are made
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The ITA Regime
• “at risk amount” – ss. 96(2.2)
• “tax shelter” – s. 237.1
• “tax shelter investment” – ss. 143.2(1)
• “limited recourse amount” – ss. 143.2(1)
• “at risk adjustment” – ss. 143.2(2)
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Calculating the At-risk Amount
• Ss. 96(2.2):
• defines at-risk amount “at any
particular time”
• starting point is A.C.B. – 96(2.2)(a)
• add share of current year income
allocated to partner – 96(2.2)(b)
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Adjustments to At-risk Amount
Decrease by:
• Amounts owing by partner to
partnership – 96(2.2)(c) (but
excluding any 143.2 adjustments)
• “Amount” or “benefit” to which
partner may be entitled – 96(2.2)(d)
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Tax Shelters
• Concept – no deductions allowed in
respect of a “Tax Shelter” unless the
shelter is registered
• Statute-barred rules do not apply
• Originally, registration was virtually
automatic
• Now see 4 page application for
registration number (form T5001) plus
11 page guide to completing it
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Tax Shelters
• Expansive definition in ss. 237.1(1)
• Not restricted to partnership interests
– catches direct investments as well
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Tax Shelters
Rules applicable when:
• Losses or amounts “represented to
be deductible”
• equal or exceed cost of the
investment, less related prescribed
benefits
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Statements and Representations
• Maege 2006 TCC 117
• Baxter 2006 TCC 230, rev’d 2007
FCA 172
• Makuz et al 2006 TCC 263
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Tax Shelter Mechanics
• “Promoter” must apply for registration
• Broad definition of “promoter”
• Includes:
• “advisers” in respect of the sale or issuance, and
• Anyone who accepts consideration in respect of the tax shelter
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Tax Shelter Investment
• Multi-part definition in ss. 143.2(1)
• Property that is a tax shelter under 237.1
• Taxpayer’s interest in a partnership
where
• an interest in the taxpayer
• Is a tax shelter investment and
• The taxpayer’s partnership interest
would be a tax shelter investment (!!)
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Tax Shelter Investment
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Limited Partnership
Limited PartnersGeneral
Partner
Asset or Expenditure Q – tax shelter investment?
Q – tax shelter?
Or Tax shelter investment?
Tax Shelter Investment
• Note that a LP unit can be a “tax shelter” under 237.1
• This would mean that all LPs holding similar units would hold tax shelter investments under para (a) of TSI definition
• But if the LP units are not generically tax shelters, one individual LP might hold his/her unit as a TSI under (b)
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Tax Shelter Investment
• If LP unit is not generically a TSI, how
could it become TSI in the hands of a
particular LP?
• Statements or representations
made to that particular LP
• Limited recourse financing of that
LPs interest
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Consequences of TSI status
• If the interest of any investor is a tax
shelter investment, then the interests of
all other investors become TSI also –
see subpara. (b)(ii) of definition of TSI
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Indirect TSI
• Consider situation where partnership
units are not themselves “tax shelters”
under 237.1
• However, partnership acquires property
or incurs an expense with a “limited
recourse debt” per 143.2(7)
• Limited recourse amount becomes a
“prescribed benefit” under Reg. 231(6.1)
• So underlying asset or expenditure
becomes a tax shelter under 237.1May 27, 2010 2010 Tax Law for Lawyers 46
Tax Shelter Cost Reduction
Cost of property/amount of expenditure
reduced by:
• All “limited-recourse amounts” of the
taxpayer reasonably related to the
expenditure, plus
• The taxpayer’s “at-risk adjustment” in
respect of the expenditure
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At-Risk Adjustment
• any amount or benefit
• taxpayer may receive or obtain
• at any time
• to reduce any loss in respect of the
expenditure or property
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Limited Recourse Amount
• 143.2(1) definition – recourse for any
unpaid principal amount is limited,
either immediately or in the future,
either absolutely or contingently
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Limited Recourse Amounts
• 143.2(7) extends definition to include
unpaid principal amounts unless
• Bona fide arrangements made at
time debt arose for repayment of
principal and interest “within a
reasonable period not exceeding
10 years” and
• Interest paid annually > prescribed
rate at time debt incurred
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Limited Recourse Amount
• 143.2(8) further extends definition –unpaid amount of debt deemed to be LRA where the taxpayer is a partnership and recourse against any member of the partnership in respect of the debt is limited
• So any debt of a limited partnership (or LLP!) becomes a limited recourse debt (including bank operating lines, mortgages, lines of credit, accounts payable)
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Limited Recourse Amounts
• Unpaid principal of limited recourse debt
• Any debt of a limited partnership
• Debt repayable in more than 10 years
• Compound interest debt
• Debt with balloon interest payments
• Debt with no fixed payment terms – eg.
inter-corporate accounts
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Consequences of LRA• Cost of property or amount of
expenditure reduced under 143.2(6)
• If the units of the LP are tax shelters in
their own right, any expenditure of the
LP incurred with debt is reduced by the
amount of the LRA
• So unless LP pays cash up front to its
suppliers, it can’t recognize the
expense!!!
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Examples of Unexpected
Application of these Rules
• Inter-corporate debt
• Line of credit
• Employee share purchase plan with
downside protection
• Long term financing of revenue
producing asset
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Planning with Limited
Partnerships
• Any “at risk” adjustments under 96(2.2)?
• Any “tax shelter” issues under 237.1?
• Any “limited recourse adjustments” under
143.2?
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Estate Planning with
Partnerships
• Krauss – no impediment in ITA to using
partnership as estate planning vehicle
• Same problem as corporation –
ensuring no transfer of value to other
members of the partnership
• Converting a family trust into a limited
partnership can solve timing issues in
succession planning
May 27, 2010 Osgoode Hall Law School 2006 LLM 56
Tax Shelter Opinions• Check the scope of the opinion – what
assumptions have been made? Have the critical issues been assumed away?
• Have the facts been independently verified, or is opinion based strictly on information presented by promoter? How?
• Does opinion reflect the transactions described in the securities offering document?
• Reality check = does OM reflect every transaction in the series?
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