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 Instant Partnerships | Allocation of Partnership Income | Computation of Partnership Income | Transfer of Property to a Partnership | Real Property Transfer to Partnerships | Incorporation of a Partnership
A partnership structure is common in farming businesses. A partnership is not defined in the Income Tax Act, but generally speaking, a partnership is the relationship between persons carrying on business in common with a view to profit. Co-ownership of property does not itself create a partnership.
To date, the Canada Revenue Agency has been extremely liberal in the determination of what does or does not constitute a partnership for income tax purposes. The legal question of whether a partnership exists can be very important not only for tax purposes, but because of the risk of joint and several liability that accompanies a partnership. The following factors have generally been considered to indicate a partnership:
  • An agreement to share profits of a business
  • Ability of each partner to contractually bind the other partners as well as the firm
  • Use of the words “partner” or “partnership” in written documentation
  • Some provision for continuing duration of the relationship between the parties
  • Use of a firm name, joint bank account, joint accounting, etc.
  • Formal registration, if any, as a partnership
Instant Partnerships

In some situations, taxpayers (usually spouses) have decided to split income by changing to a partnership from a proprietorship - with perhaps income splitting by payment of wages or management fees to the non-farming spouse. This change is often made without election forms or other tax planning. A partnership statement often deducts interest on funds borrowed for land and property taxes and shows the tax depreciation pools as a partnership calculation.
Significant concerns exist with this change to a partnership. Since interest, property taxes and depreciation are calculated and adjusted at the partnership level, the indication is that the assets (land, buildings and equipment) have been transferred to the partnership. The Canada Revenue Agency may be of the view that this is a disposition at fair market value of the assets, and the resulting capital gains, income and recaptured depreciation should be reported (and tax paid). This outcome can be avoided by proper planning and filing of the appropriate election forms.

Allocation of Partnership Income

The allocation of income is ordinarily established in the partnership agreement. In some cases this will be fairly straightforward (e.g. equal share), but in other instances, the allocation might be more complex.
Consider, for example, the situation where one of two partners will be providing all the effort, and the other partner will not be active in the partnership business on a day-to-day basis. The partners may agree that the active partner should receive extra income and therefore allocate the first $20,000 of income to the active partner. They then share all remaining profits equally. This extra allocation is often referred to as a wage, but in fact, partnerships cannot deduct wages to partners; therefore, it is simply an allocation of income.

Tips and Traps
  • The Income Tax Act provides the Canada Revenue Agency with the discretion to challenge allocations if they seem unreasonable.
  • Consider a situation where members of a partnership agree to share any income or loss from any source. If the principal reason for the agreement may reasonably be considered to be a reduction or postponement of tax, then the share of each partner is deemed to be that amount which is reasonable in the circumstances.
  • Another situation that may be a problem concerns two or more members of the partnership, who are not dealing at arm's length, and the share of the income or loss is not reasonable having regard to capital invested, work performed, or any other relevant factor. Then, notwithstanding the agreement, their share will be deemed to be an amount that is reasonable in the circumstances.
  • A farmer may want to consider the flexibility of income allocation between an active and inactive partner. An allocation could be paid to the active partners prior to the final partnership allocation amongst all partners.
Computation of Partnership Income

A partnership is not a person for tax purposes, but Section 96 of the Income Tax Act does provide that the income of a partnership should be computed as if the partnership were a separate person resident in Canada. The partners must recognize their share of partnership income in the year in which the partnership’s taxation year ends. Each partner is taxed on his or her share of the partnership income for each year and on any capital gain realized upon the disposition of his or her partnership interest.

Tips and Traps
  • Taxation year of the partnership is its fiscal period.
  • Capital cost allowance is claimed at the partnership level on partnership assets. Assets held outside the partnership can be depreciated at the owner's discretion, but there is a question as to whether they must be leased to the partnership to trigger capital cost allowance.
  • Reserves and elective amounts are also claimed at the partnership level (e.g. doubtful debts, mandatory inventory adjustments and optional inventory adjustments).
  • Charitable and political donations must be added back to partnership income, and each partner claims a tax credit for their proportionate share.
  • Salaries paid to partners do not constitute a business expense but are a method of distributing income.
  • Rent paid to a partner is an expense to the partnership and income to the partner. (Don't forget that such transactions may be subject to GST.).
  • Interest paid to a partner is normally considered to be a distribution of income and not an expense. However, a partnership can enter into a true lender-borrower relationship with interest as an expense, but interested parties should seek legal advice on how this is best evidenced.
  • A partner may deduct expenses incurred personally in earning partnership income.
  • A partnership of companies must consider specified partnership income (SPI) and the small business deduction (SBD) calculation. This restricts the use of a partnership to multiply the SBD by limiting the use of the SBD to the particular partner's percentage share of the partnership.
For example: Corporation A is a 50 per cent partner in a partnership carrying on active business. The partnership has net income for the year of $600,000 of which Corporation A is entitled to 50 per cent ($300,000). Assuming no other operations in Corp. A, the SBD is limited to $250,000 of net income (i.e. 50 per cent of $500,000 SBD overall limit).

Transfer of Property to a Partnership

When a taxpayer transfers property to a partnership and becomes a partner, normally the property is deemed to be disposed of for fair market value (per Subsection 97(1)). Where the partnership is a “Canadian partnership,” the property may be transferred at a value other than fair market value (with the appropriate election).
A “Canadian partnership” is defined as a partnership in which all the members are resident in Canada at the time at which the term is being considered. When an election is made according to 97(2), a taxpayer may transfer property to a partnership on a tax-free rollover basis by choosing an elected amount equal to the cost amount of the property being transferred (and therefore defer the inherent gain). The elected amount will form proceeds for the transferor and also the cost to the acquiring Canadian partnership.

Tips and Traps - Subsection 97(2) Election
  • If the transferor receives any consideration other than the partnership interest, the elected amount may not be less than the value of that other consideration.
  • If depreciable property is transferred, the partnership will be deemed to have the partner's historical cost (i.e. for recapture purposes).
  • Paragraph 13 (7) (e) limits the cost of a depreciable acquired from a non-arm's length person to the cost of transferor plus one-half of the excess of the transferor's proceeds over historical capital cost.
  • In situations where the transferor has sheltered a capital gain with the capital gain exemption, Paragraph 13 (7) (e) (i) further reduces the depreciable amount where the property was acquired from a non-arm's length person by another amount. Similar rules exist for eligible capital property.
  • Roll-in rules that apply on a rollover to a corporation under Section 85 are equally applicable to 97 (2).
  • Regulation 1102(14) provides that depreciable property acquired from a non-arm's length person will remain property of the same class it was when owned by the transferor
  • There is no requirement to receive an interest in the partnership in consideration of the transfer as long as the transferor is a partner immediately after the transfer.
  • Property eligible for a 97 (2) election includes any capital property, Canadian resource property, eligible capital property or an inventory (note that unlike Section 85, there is no prohibition with respect to real property inventory).
  • Subsection 40 (3.4) contains special rules to prevent a majority partner from realizing a capital loss on a transfer of property to a partnership.
  • Is it possible to use a partnership to dispose of an asset to an arm’s length party and defer all gains?
Example: A taxpayer owns property that would result in taxable gains on a straight sale. The taxpayer and the purchaser form a partnership, and the taxpayer transfers the property to the partnership using Subsection 97(2) to defer the recognition of the gain. The purchaser contributes cash to the partnership, which the taxpayer withdraws, and because of the withdrawal, the taxpayer’s share of the income and loss of the partnership is reduced. The partnership continues to carry on business.
The Canada Revenue Agency has dealt with this possibility directly in Information Circular 88-2 and threatens to apply the General Anti- Avoidance Rule (GAAR). The rule considers the use of the partnership to be an attempt to circumvent the provisions that dispositions of property are to be accounted for at the time of receipt, and the action would be contrary to the scheme of the Income Tax Act read as a whole. Therefore, 245(2) would apply to deny the tax benefits sought, and tax would be payable immediately.

Real Property Transfer to Partnerships

Unlike Section 85, Subsection 97(2) contains no prohibitions on the transfer of real property inventory into a partnership. This option could be used to indirectly incorporate real property inventory by first using a rollover to a partnership and then incorporating the partnership interest by transferring the interest to a corporation under Section 85. The Canada Revenue Agency has confirmed that the partnership interest itself would not be deemed to be real property.

Tips and Traps

  • Watch out for the General Anti-Avoidance Rule if this method is chosen to circumvent the prohibition in Section 85
  • When dealing with farmland (where it is a capital asset), you may not wish to use Subsection 97 (2) but rather have a sale occur at fair market value to trigger a capital gain that would be eligible for the capital gains exemption. In some cases, a Subsection 97 (2) election is still desirable to control the amount of capital gain to be triggered.
  • This approach is applicable where the potential gain exceeds the available capital gains exemption or where a lower capital gain is desired to minimize the alternative minimum tax. Similar to an election under Section 85, an elected amount can be chosen on the election to trigger the appropriate amount of the gain.
  • Even if you intend to trigger the entire capital gain on land, it may still be wise to file a Subsection 97 (2) election if there is some concern that the value of the land could be higher than estimated fair market value. This election would provide some protection against a reassessment that might otherwise increase the reported capital gain.
Incorporation of a Partnership

Two different methods exist to incorporate:
A. Incorporation of the assets of the partnership followed by wind-up of the partnership
B. Incorporation of the interests in the partnership followed by wind-up of the partnership into the company

A. Incorporation of partnership assets
Partnership property may be transferred to a corporation in exchange for shares using Subsections 85(2) and 85 (3). Once the transfer of partnership assets to the corporation in exchange for its shares is complete, the partnership must be wound up within 60 days of that exchange so that the partners receive those shares of the corporation held by the partnership. In this manner, the object of dissolving the partnership and transferring the business to a corporation can be accomplished without the realization of taxable gains or losses

Tips and Traps
  • If a business is expected to have start-up losses or if the business has quick write-offs available, consider beginning the business in a partnership form. This approach would allow early losses or write-offs to flow through to the owners who would then eventually incorporate the partnership property (consider non-tax items such as liability concerns).
  • Note that the receiving company must be a Canadian corporation for rollovers to occur, and The Canada Revenue Agency requires that the transfers must occur to only one corporation (otherwise a partnership "butterfly" or splitting up of the partnership could occur). This result would be offensive to The Canada Revenue Agency since it would allow a tax-free division of partnership assets. Such a division is not provided for in the Income Tax Act.
  • The first step is the transfer of assets by the partnership to the corporation in accordance with a Subsection 85 (2) election. Note that all members of the partnership must jointly elect and file form T2058 (although Powers of Attorney are used in widely-held partnerships)
  • As consideration for the transfer of assets to the corporation, the partnership must receive at least one share of the capital stock of the corporation. However in practice, the number issued is determined by the need for shares in dissolving the partnership. For administrative ease, the shares are sometimes issued in the name of the partners rather than the partnership, and The Canada Revenue Agency's view is that this procedure does not invalidate the application of Subsection 85 (2) or 85 (3) .
  • For Subsection 85 (3) to allow a tax-free distribution of the partnership, the only assets the partnership can hold are money or property received from the corporation as consideration for the disposition.
  • If triggering a capital gain on the transfer of any depreciable assets by the partnership to a non-arm's length corporation, be aware of Paragraph 13 (7)(e). This stipulation will limit the depreciable cost to the corporation to the historical capital cost plus one half of the capital gain less twice the amount of any capital gain exemption deducted.
  • Subsection 40 (3.6) does not allow a partnership to claim a loss on the disposition of eligible capital property or capital property to a corporation if the partnership controls the corporation immediately after the disposition.
  • Consequences of the partnership wind-up - assuming conditions met so that 85 (3) applies:
  • non-share consideration distributed to partners will have a cost amount equal to its fair market value
  • this non-share consideration will reduce the partner's adjusted cost base (ACB) of the partnership interest (for allocation to shares received)
  • adjusted cost base of shares distributed will be limited to the amount of any ACB the partner still has remaining in his or her partnership interest (with cost first being allocated to preferred shares up to their fair market value and any residue to common shares)
  • ·the partnership will be deemed to have disposed of its property immediately before the dissolution at the tax-carrying value of the property
  • Subsection 85 (2) and 85 (3) transfers may not always be tax-free: a partner may realize a capital gain where the fair market value of the non-share consideration received is more than the adjusted cost base of the partnership interest.
B. Incorporation of partnership interests
A partnership interest can be transferred to a corporation in accordance with an 85(1) election. Assuming all interests are transferred to the corporation, then 98(5) may apply to allow a tax-free wind-up of the partnership. A “bump” of the cost base of certain assets may be available if the cost base of the partnership interests is greater than the partnership’s net assets.

Tips and Traps
  • On the transfer of the partnership interests, consider electing high enough to trigger a capital gain exemption if the partnership qualifies for the purposes of the capital gains exemption (and assuming the exemption is available to the vendor partner).
  • This method of incorporating a partnership can result in a capital gain on the dissolution of the partnership if the cost base of the partnership interests to the company is less than the cost amount of partnership properties.
  • A partnership interest can be transferred to a corporation in accordance with a Subsection 85 (1) election. This election can be used to limit the amount of the capital gain that would otherwise result by electing at the appropriate amount. Note, however, that if the adjusted cost base of the interest is negative, a capital gain will result since the minimum elected amount is $1. If the partnership qualifies for the enhanced capital gains exemption, the fact that the capital gain results from a negative cost base does not preclude claiming the exemption.
  • If all partnership interests are transferred to one corporation, the partnership will cease to exist, and Subsection 98(5) may apply to the partnership.
  • Subsection 98(5) applies where a Canadian partnership ceases to exist, and within three months, a partner carries on what used to be the partnership's business and continues to use some of the property that was partnership property received as proceeds of disposition of his or her partnership interest.
  • Subsection 98 (5) provides:
  • partnership deemed to dispose of its assets at cost amount rather than fair market value (other than property transferred prior to acquisition of former partners' partnership interest by the proprietor)
  • proprietor deemed to dispose of partnership interest for the greater of:
    a. adjusted cost base of interest together with cost of all interest purchased from other partners
    b. cost amount of all partnership properties
Therefore it is possible that a capital gain could result on the dissolution of the partnership.
  • On the rollover during the lifetime of a partner in a farm partnership, a negative cost base will result in an immediate capital gain on the transfer to a child or spouse to the extent of the negative amount (even though the partnership would otherwise qualify for rollover).
  • A "bump" is available under 98(5) for non-depreciable capital property to the extent that the partner/proprietor's adjusted cost base in the partnership is greater than the net assets of the partnership. In very limited circumstances, a "bump" may be available for depreciable properties as well (where partnership existed before December 4, 1985).
  • Rules in 98 (5) are not elective, but rather apply automatically.
Land Registration
  • Land cannot be registered in partnership name;
  • Often simply registered in the partners' names;
  • May consider registering a caveat against the title to protect the partnership ownership;
  • May use a bare trustee corporation to hold the land for the partnership.
Partnership Rollover and Mandatory Inventory Rules
  • Subsection 85 (1) (c.2) applies to rollovers to corporations and partnerships. The section provides that the minimum elected amount for the rollover provisions relating to cash basis farm inventory is restricted to that amount which would have been included in income under Mandatory Inventory Adjustment rules (28(1) (c)
  • Prevents the creation of a farm loss by rolling over purchased inventory before the year end of the taxpayer or partnership. See paragraphs 12 and 13 of Interpretation Bulletin 427R.
Problem with Debt in Excess of Cost of Assets on Rollover to a Partnership
  • An individual may wish to rollover a cattle herd to a partnership but has debt of more than the cost of the cattle that he or she wishes the partnership to assume.
  • If the rollover is done under such circumstances, the transfer value elected must at least be equal to the debt assumed and income would result.
  • If the debt creates an income problem, a strategy is to roll the inventory for $1. Subsequently, the partnership borrows an amount from the bank and pays it out as a capital distribution (creating a negative cost base). The Canada Revenue Agency may use the General Anti-Avoidance Rule to attack, especially if transactions occur in quick succession, and require the individual to be taxed on proceeds received on the inventory.
Using a Partnership to Access the Capital Gains Exemption on Farm Assets
  • Farmer A and his child wish to use the capital gains exemption in the course of incorporating their farming business.
  • Unfortunately, the majority of value of their farming assets rests in their cattle herd which has no tax basis - only nominal capital gains exist on their land .
  • Farmer A and his child propose to transfer their respective farm assets to a partnership on a rollover basis. Subsequently, they will transfer their partnership interests into a corporation and create a capital gain on which to claim their capital gains exemption.
What Will the Canada Revenue Agency Think of This Approach?
If the transfers to the partnership and, subsequently, of the partnership interest to a corporation occur within a short time, the Canada Revenue Agency could argue the partnership interests are held because of income rather than capital account. Therefore income rather than a capital gain would result. Alternatively, The Canada Revenue Agency may seek to use General Anti-Avoidance Rule to re-characterize the transactions as merely a transfer of assets to a corporation (therefore not crystallizing the same amount of capital gain).

Note that 54.2 of the Income Tax Act provides that where a proprietor rolls assets into a corporation and then sells the shares of the corporation shortly after, the shares are deemed to be capital property. But this provision does not appear to extend to the situation described above.

It is necessary for the farm partnership to be in existence for 24 months to qualify for the enhanced capital gains exemption available for qualified farm property. The Canada Revenue Agency has indicated this condition in a private interpretation.
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For more information about the content of this document, contact Joel Bokenfohr.
This document is maintained by Nicole Halvorson.
This information published to the web on July 24, 2014.