CHOICE OF BUSINESS VEHICLES

Transcription

1 THE CANADIAN BAR ASSOCIATION CLE Seminar "Tax Law for Lawyers" May 30 to June 4, 2010 Niagara-on-the-Lake, Ontario CHOICE OF BUSINESS VEHICLES AN ANALYSIS AND COMPARISON OF INCOME TAX DISTINCTIONS By Richard Lewin HEENAN BLAIKIE LLP Bay Adelaide Centre Suite 2900, 333 Bay Street Toronto, ON M5H 2T4 Tel. (416) Fax 1 (866) rlewin@heenan.ca

2 CHOICE OF BUSINESS VEHICLES Ideally, the structure selected to carry on a business should depend strictly upon business considerations and not necessarily be governed by income tax concerns. The computations of income and income tax, however, may play a role in determining the type of vehicle that is used to carry on a particular business activity. The objective of this paper is to set out some of the principal income tax and capital tax issues that play a role in evaluating the choice of business vehicle to be used. How one carries on a business, however, should not be motivated solely by income tax considerations. Legal liability attached to the business activity, administrative ease and practicality should be equal if not overriding obligations. Time and space preclude a completely exhaustive discussion of the subject and the articles set out in the bibliography annexed to this paper may provide further insight into this complex issue. Tax rules tend to change with frequent regularity and one must ensure that comments in any particular paper have not been overridden by subsequent changes to the Income Tax Act. The business vehicles which will be reviewed are - sole proprietorships - partnerships - joint ventures - corporations - limited liability corporations or unlimited liability corporations - business trusts or income trusts and what are commonly referred to as real estate investment trusts and oil and gas royalty trusts, and - mutual fund trusts This paper will highlight the principal differences in the computations of income, taxable income and income tax payable of the structures described above.

3 - 2 - PROPRIETORSHIPS Introduction The simplest way to carry on a business is by sole proprietorship. This requires the fewest formal administrative steps that any business vehicle must undertake to commence business and is likely the easiest to administer. Since the individual carries on business directly, it is the individual who is subject to income tax. An individual may elect to carry on business as a sole proprietor for a number of reasons including: (a) A legal obligation to do so. In certain provinces certain professionals still are not entitled to incorporate. (b) The size of the business may not make it efficient to incorporate. Incorporation requires a one-time incorporation and set-up fee cost, and annual costs of preparing corporate records and filing government information returns. A smaller business may prefer to conduct itself as a proprietorship to avoid these costs. (c) The business may incur losses at the outset which the individual may wish to use to offset against other sources of income. A more detailed discussion of this matter is set out in the section entitled Partnerships. (d) The Income Tax Act 1 generally contains sufficiently broad provisions enabling an individual to transfer a business either to a partnership or a corporation at a future time without incurring an income tax liability. Transfers of real estate, in certain circumstances, may not benefit from these rules. An individual who elects to carry on business as a sole proprietorship is obliged, as are all taxpayers, to compute income or loss from a business in accordance with the provisions of 1 R.S.C (5th Supp.), c.1, as amended. All statutory references are to the Income Tax Act (the Act ) unless otherwise indicated.

4 - 3 - subdivision b of division A of part I. The income or loss from a business or property is the individual s profit or loss from that business or property. 2 The remaining provisions of subdivision b, together with other provisions of the Act, modify that computation of profit to obtain a computation of income or loss, as the case may be. The concept of profit is not defined in the Act. In Canderel Limited v. The Queen 3, the Supreme Court held that the determination of profit is a question of law and that generally accepted accounting principles are not rules of law but interpretative aids In fact, the better view is that G.A.A.P. will generally form the very foundation of the well-accepted business principles applicable in computing profit. It is important, however, for the courts to avoid delegating the criteria for the legal test of profit to the accounting profession, and therefore a distinction must be maintained. That is, while G.A.A.P. may more often than not parallel the wellaccepted business principles recognized by the law, there may be occasions on which they will differ, and on such occasions the latter must prevail. 4 Fiscal Period An individual's taxation year is the calendar year. 5 An individual 6 who carries on a business 7 (either as a proprietor or as a partner) generally is required to adopt December 31 as the end of the fiscal period. 8 An individual who carries on a prescribed business (none currently are Subsections 9(1) and 9(2). 98 DTC 6100) (SCC). Ibid. at page Paragraph 249(1)(b). 6 An individual includes a trust for the purposes of the Act. Testamentary trusts and other individuals that are tax exempt entities are excluded from this rule. 7 Ownership of rental property may not constitute a business, for example, unless ancillary services are provided to tenants. See, for example, Walsh and Micay v. MNR (65 DTC 5293 Ex Ct). 8 Paragraph 249.1(1)(b). The definition of fiscal period in subsection 249.1(1) is the same as the previous definition in subsection 248(1) except that it deems fiscal periods of individuals and certain partnerships to end on December 31. The rule as it applies to partnerships will be discussed under that heading.

5 - 4 - prescribed) or who carries on a business outside Canada may adopt a fiscal period that ends other than on December 31 only for such business. Income Tax Payable The rates of income tax payable by an individual differ from the rates of income tax payable by a corporation. Appendix A and Appendix B respectively set out the combined income tax rates of the federal government and each of the provinces and territories of Canada for an individual and for a corporation. Although corporate income tax rates often are lower than individual rates, a distribution to an individual of corporate profits results in a second level of income tax in the hands of the individual shareholder which may result in an overall greater income tax liability than if the income had been earned directly by the individual. Individuals who might otherwise wish to carry on an active business by way of proprietorship nevertheless may find it advantageous to incorporate the business to reduce the overall income tax cost. The changes to the Act creating the concept of eligible dividend adds to this advantage. Take, for example, a business that earns $800,000 in a fiscal period which, if earned by a corporation, would be income of the corporation for the year from an active business. 9 Assume, further, that if the income were earned by a corporation, the individual would receive a salary of $200,000. $500,000 of the corporate income of $600,000 is eligible for the small business deduction. 10 The following compares the 2010 calendar year income tax liability of (i) an individual residing in the province of either Quebec or Alberta carrying on a business as a sole proprietor with (ii) the income tax liability of the individual (in respect of the salary) and the corporation in respect of its income. 9 Subsection 125(7). The definition includes the corporation's income for the year from an active business carried on by it other than income from a source in Canada that is property. Active business is defined in this same subsection essentially to mean any business carried on by a corporation other than a specified investment business or a personal services business. 10 Section 125. Most provinces are increasing their small business deduction to this amount.

6 EXAMPLE QUEBEC PROPRIETORSHIP CORPORATION Individual tax $385,760 - Individual tax salary - $88,000 Corporate tax (SBDI) - 95,000 Corporate tax (remaining income) - 29,900 Total Income Taxes $385,760 $136,800 Tax on distribution of remaining 349,700 corporate income of $387,100 ($69,000 will be designated as an eligible dividend) Total Income Taxes $385,760 $353,611 ALBERTA Individual tax $312,000 - Individual tax salary - $78,000 Corporate tax (SBDI) - 70,000 Corporate tax (remaining income) - 28,020 Total Income Taxes $312,000 $176,020 Tax on distribution of $424, ,400 remaining corporate income of ($69,000 will be designated as an eligible dividend) Total Income Taxes $312,000 $284,420 This example shows that both in Quebec and Alberta the aggregate income tax liability of an individual carrying on a business in a proprietorship exceeds the aggregate corporate and individual income tax liability of a business carried on by a corporation. From a tax perspective, clearly a corporation is preferable. To the extent that profits are distributed, that amount is taxable as a dividend adding to the aggregate tax cost of a corporation operating a business. Nevertheless, the aggregate tax cost still is less when a corporation is used to carry on a business. Please note that the benefits are not so evident where the income is active but not eligible for the small business deduction (see page 7-9).

7 - 6 - The extent of the actual additional income tax cost is difficult to quantify and depends, in part, upon the delay between the earning of the profits and their distribution by way of dividend, and whether the corporate income was eligible for the small business deduction. In addition, this additional income tax liability may be reduced or even eliminated if the children and/or the spouse of the individual are shareholders of the corporation taxable at below the maximum marginal income tax rates and who may receive dividends without application of the income attribution rules. When tax reform was introduced in 1972, one of the underlying philosophies was the concept of integration with respect to investment income. Simply put, this means that the tax effect on investment income earned by a corporation and then distributed to a shareholder should be the same as the tax effect on that investment income if earned directly by an individual. The concepts of refundable dividend tax on hand, the dividend gross-up, the dividend tax credit and the capital dividend account are mechanisms used to achieve this concept. Integration was applicable only to private corporations and their shareholders. Specifically, the concept of integration did not extend to the earning of business income. The impetus for integration in respect of business income was the growing popularity of the income trust. $1 of business income earned by an income trust resulted in a 46 tax cost to an Ontario resident. If that $1 was earned by a corporation and the after tax profit was distributed as a dividend, the combined corporate and shareholder tax was 56. To combat the income tax advantages arising from the use of an income trust, amendments were introduced in 2006 to provide for integration with respect to business income.. Prior to such amendments, all dividends received by an individual from a Canadian corporation were subject to a gross up of 25% and a dividend tax credit equal to 2/3 of that gross up (13.33% of the taxable dividend). To provide for greater integration, the gross up in respect of eligible dividends 11 was increased to 45% and 11 Definition in subsection 89(1).

8 - 7 - the tax credit became 11/18 ths of the gross up. Currently, the federal gross up is 44% 12 and the federal tax credit is 11/17th 13 of the gross up. A corporation resident in Canada is entitled to designate that a dividend paid by it be an eligible dividend. In theory, all dividends from a corporation that is not a Canadian-controlled private corporation ( CCPC ) should be considered eligible dividends. The concept of a low rate income pool ( LRIP ) can affect the calculation of eligible dividends of a non-ccpc. Dividends paid by a CCPC can be designated as eligible dividends to the extent of its general rate income pool ( GRIP ). In simple terms, this pool will include 68% of business income that was not eligible for the small business deduction and the aggregate of all eligible dividends it has received. 14 The various GRIP definitions contained in subsections 89(4) to and inclusive 89(7) and the LRIP definitions contained in subsections 89(8) to and including 89(10) are sufficiently complex for a separate paper. For a dividend to be an eligible dividend, subsection 89(14) requires that the corporate payer designate the amount to its shareholders. Designation occurs by notifying the dividend recipients at the time of designation. CRA will consider that a public corporation has made a designation where it publicly states on its website reports to shareholders or in a public release that all dividends paid are eligible dividends. All other corporations must provide notification by letter, by referring to it on the cheque or by noting it in minutes where all shareholders are directors. If the amount is not designated, it is not an eligible dividend and, therefore, the concept of excessive eligible dividend designation 15 and the penalty provisions contained in section will become applicable. The designation must be made in respect of the full dividend paid. If a portion of the dividend is designated, it is an invalid designation. If a corporation is paying a dividend in an amount in 12 As corporate tax rates decline, the gross-up and tax credit decline and increase the tax payable on the dividends. The gross-up reduces to 41% in 2011 and 38% thereafter. 13 The tax credit reduces to 13/23 in 2011 and 6/11 thereafter. 14 Subsection 89(1). 15 Definition in subsection 89(1).

9 - 8 - excess of GRIP, it should consider paying one dividend equal to the amount it wishes to designate and pay a second dividend for the balance. Appendix D sets out the tax rates for eligible dividends and the tax rate for dividends that are not eligible dividends. To explore whether integration has been achieved, below are calculations of both the corporate tax on $100,000 of business income and the individual tax on the dividend (the $100,000 less the corporate tax) where the lesser of the dividend or $69,000 (the increase to GRIP in respect of the corporate income) designated as an eligible dividend in respect of the provinces of Quebec, Ontario and Alberta. EXAMPLE: QUEBEC Corporate tax $29,900 Individual tax 21,600 $51,500 Individual Maximum Marginal Tax Rate 48.2% ONTARIO Corporate tax $30,000 Individual tax 18,650 $48,650 Individual Maximum Marginal Tax Rate 46.4% ALBERTA Corporate tax $28,000 Individual tax 11,780 $39,780 Individual Maximum Marginal Tax Rate 39% As the examples demonstrate, integration has not been fully achieved.

10 - 9 - Income Tax Distinctions - Individual and Corporation There are a number of differences in the computation of income tax payable by an individual and by a corporation. Three will be briefly examined here while the others will be reviewed under the heading Corporations. The first example is minimum tax. An individual is required to compute, pursuant to section 127.5, an alternate calculation of income tax. This is equal to 15% (23% for Quebec purposes), before surtax, of the individual's adjusted taxable income less the basic exemption which is currently $40,000 ($25,000 for Quebec purposes). If this minimum tax exceeds the actual income tax payable by the individual in the taxation year, this greater income tax liability is due. This minimum tax is payable only by individuals and not by corporations. A second contrast is the tax liability under part XIV. This liability applies only to a corporation carrying on business in Canada, other than a corporation that was a Canadian corporation throughout the year. 16 Individuals, including non-residents, who carry on a business in Canada through a proprietorship, are not subject to this part XIV tax. Lastly, certain provinces impose a capital tax on corporations only. Provincial capital tax rates are set out in Appendix C. 16 Subsection 219(1). Part XIV makes no reference to an income tax liability on individuals. The income tax liability is equal to 25% of a somewhat detailed calculation. Part XIV levies an income tax essentially on nonresident corporations carrying on a business in Canada to compensate for the fact that a branch pays no dividends which, when paid to a non-resident (by a Canadian resident corporation), are subject to withholding.

11 PARTNERSHIPS Introduction Partnerships have existed for centuries. 17 Their use as a business vehicle results, in part, because taxation rules in Canada flow income or loss of a partnership through to its partners. 18 A partnership can be a general partnership, a limited partnership or a limited liability partnership ( LLP ). A general partnership provides that each partner is jointly and severally liable for the obligations incurred by the partnership, exposing all of the assets of a general partner to the business risks arising from the conduct of the partnership's affairs. A limited partnership, which is created by statute, provides for two classes of partners: general partners who are jointly and severally liable for the obligations of the partnership, and limited partners who are liable for the obligations of the partnership only to the extent of their contributions to the limited partnership. 19 A LLP also is created by statute and applies to partnerships of professionals. Generally, personal liability does not arise except if the partner is considered to have been involved in negligence relating to a client s activities. It is the ability of partners to limit their liability through the creation of limited partnerships that also has increased the utility of partnerships For an excellent article, see Robert G. Witterick, Q.C., The Partnership as a Modern Business Vehicle, in Report on Proceedings of the 41st Tax Conference, 1989 Conference Report (Toronto: Canadian Tax Foundation, 1989, 21:1-25). 18 Subsection 96(1). 19 See, for example, the Limited Partnerships Act, R.S.O. 1990, c. L.16, which is the legislation establishing limited partnerships in the province of Ontario. 20 For a discussion of a comparison of the relative advantages and disadvantages of carrying on a business through a partnership or through a corporation, see Douglas S. Ewens, Partnerships and Corporations - A Comparison of Related Advantages and Disadvantages, Report of Proceedings of the 33rd Tax Conference, 1991 Conference Report (Toronto: Canadian Tax Foundation, 1982),

12 Characteristics A partnership commonly is defined as the relationship that subsists between persons carrying on business in common with a view to profit. 21 While partnership law differs from province to province, there are three elements that are common to all partnerships: (a) The parties must carry on a business in common. It is suggested in Lindley on the Law of Partnership that the definition of business would include virtually any commercial activity or adventure. 22 (b) A partnership must involve more than one person. While a person generally does not include a partnership, each of the Limited Partnership Act (Ontario), 23 and the British Columbia Partnership Act, 24 for example, permit a partnership to be a member of another partnership. Since a constituent element of a partnership is that a business be carried on, if a partnership's sole activity is holding an interest in another partnership, can it be said to be carrying on a business? (c) The final requirement is that the parties carry on the business with a view to profit. Profit is considered by the jurisprudence to be net profit. 25 The income tax rules applicable to the taxation of a partnership and its partners differ from rules which apply to persons acting either as co-owners or as joint venturers. Parties who wish to associate as joint venturers or co-owners but not as partners must ensure that their relationship 21 See, for example, the Partnerships Act, R.S.O. 1990, c. P.5, section 2. See also Spire Freezers Ltd. v. The Queen 2001 DTC 5158 (SCC), and Backman v. The Queen 2001 DTC 5149 (SCC) where the court looked at whether a partnership, in fact, arises in the context of profitability. The Supreme Court held that once the elements of partnership are met, the reason why the partnership was created will not result in its validity being overturned. 22 Ernest H. Scamell and R.C. L'Anson Banks, Lindley on the Law of Partnership, 15th Ed., London: Sweet & Maxwell, 1984, Supra, note 16. The definition of person in section 1 includes a partnership. RSBC 1979, c A person is defined in the Interpretation Act to include a partnership. Re: Spanish Prospecting Company, Limited, (1911) 1 Ch. 92, at 99 (CA).

13 does not create a partnership. The mere statement that the parties are not a partnership should not be considered sufficient to avoid the relationship being characterized as a partnership if the principal three elements are met. Canadian jurisprudence has accepted that a joint venture may be a distinct legal relationship that is different from a partnership. There is, however, jurisprudence that supports the view that a joint venture is merely a form of partnership. 26 The Canada Revenue Agency ( CRA ) has stated that it respects provincial law as to whether or not a partnership exists. 27 CRA traditionally has been prepared to accept the holding of real estate as a joint venture or co-ownership, whether or not the relationship might be characterized as a partnership. It may be unwilling to administratively accept a joint venture as not a partnership where the purpose of avoiding characterization as a partnership is to obtain income tax benefits for the investors. To ensure that a joint venture is not a partnership the joint venture should be confined to a single project or at least have a limited duration. In addition, each joint venturer should have separate tasks to complete within the project, providing separate manpower and assets to complete such tasks. Joint venturers should be precluded from acting as agents for others and the agreement clearly should indicate that the parties are not partners. In my view, as the number of parties to a venture increase, it is more likely that the joint venture would constitute a partnership since the greater number of parties, the less involvement and the greater likelihood that the parties merely are sharing profits. In a true joint venture, in my view, each party's share of profits of the joint venture is dependent upon its activities and the manner in which each conducts its share of the joint venture activities. 26 For an analysis of the distinctions between a partnership and joint venture, see, for example, David A.G. Birnie, Partnership, Syndicate and Joint Venture: What's the Difference? in Report of the Proceedings of the 33rd Tax Conference, supra note 17, at The author summarizes some of the jurisprudence pertaining to whether a joint venture can exist separately from the concept of a partnership. 27 Interpretation Bulletin IT-90 at paragraph 2.

14 Computation of Income A partnership computes its income as if it were a separate person resident in Canada and as if its taxation year were its fiscal period. 28 While the partnership does not file an income tax return and is not a tax paying person, it generally is required to file an annual partnership information return as is prescribed in the Act. 29 Each partnership activity is considered to be carried on by the partnership as if it were a separate person, with a computation being made for each taxable capital gain and allowable capital loss. 30 The income of the partnership from a source or from sources for each taxation year is considered that of the partners, thereby providing a flow-through of the income characteristic to each partner. 31 Thus, a partner carries on a business if the partnership carries on a business, even if the partner is a limited partner. This is relevant because a partner will be considered to carry on the business in each province where the partnership has an establishment. Furthermore, if the partnership carries on a business in Canada, non-resident partners also will be considered to be carrying on a business in Canada. The calculation of income or loss of the partnership is computed generally without reference to resource income or expenses. 32 Capital cost allowance, however, must be claimed at the level of the partnership. One distinction in the tax treatment of a partnership and other entities is that scientific research and experimental development expenditures incurred by the partnership must be deducted annually in calculating partnership income and may not be carried forward as generally Paragraphs 96(1)(a) and (b). Regulation 229 to the Act. Paragraph 96(1)(c). Paragraph 96(1)(f). Paragraph 96(1)(d).

15 permitted. 33 This obligation may affect a taxpayer's loss carry-forward position and may result in taxpayers losing a portion of their loss carry-forwards. In addition, losses with respect to scientific research and experimental development are restricted to members of partnerships who (i) are not limited partners, and (ii) who are actively engaged in the activities of the partnership and carry on a business similar to that carried on by the partnership on a regular and continuous basis throughout the year. 34 Flow-Through of Income or Losses One of the advantages of operating a business through a partnership is that losses of the partnership flow to the partners directly. This is beneficial where losses arise for income tax purposes, for example, from capital cost allowance, scientific research and experimental development expenses or significant start-up costs. In particular where the partners otherwise are profitable entities who can use the partnership losses to offset income from other sources. The advantage to a business incurring start-up costs which create a loss for income tax purposes being conducted through a partnership can be seen in the following example. Assume that two individual partners have substantial employment and/or investment income, and that their maximum marginal income tax rate is 50%. Assume, further, that the partnership of which they are equal partners incurs a $200,000 loss in its fiscal period. Since the loss is allocated to the partners, each partner can deduct in computing income its share of partnership losses of $100,000 reducing their respective income tax liability by its tax rate. Contrast this with the situation where the identical business is operated by a corporation. Although the corporation would have the identical loss, it would be unable to use the loss until it realized income. Shareholders cannot access the loss. While the corporation eventually might use the losses to reduce taxable income in a subsequent year, the benefit of reducing an immediate income tax liability does not arise. 33 Paragraph 96(1)(e.1). Subsection 37(1) permits a taxpayer to deduct in computing income in a taxation year scientific research and experimental development expenditures incurred in the year or preceding years to the extent not otherwise deducted in a preceding year. 34 Paragraph 96(1)(g) and the definition of specified member in subsection 248(1).

16 A number of flow-through issues arise where a business is conducted by a partnership. These include: (a) The partnership must deduct scientific research and experimental development expenditure costs on an annual basis. Losses resulting from such expenditures do not flow-through to all partners. (b) Interest and property taxes generally may not be deducted in computing income where they relate to land, except where the land is used in the course of a business carried on by the taxpayer other than a business of resale or development. 35 A corporation whose principal business is the leasing, rental or sale, or the development for lease, rental or sale, of real property is entitled to deduct interest, computed at a prescribed rate, in respect of a loan of $1 million. This deduction is not permitted to corporate members of a partnership although it would be permitted to corporate members of a joint venture. (c) A corporation whose shareholders include non-resident shareholders who do not deal with each other at arm's length and who hold shares that represent more than 25% of the votes or value of the shares of the corporation may be precluded from deducting in computing income all of the interest payable on debts to such shareholders unless the corporation maintains a certain debt to capital ratio. 36 Non-residents who reside in tax jurisdictions with lower income tax rates than Canada and who control a Canadian resident corporation may try to minimize the income of its Canadian subsidiary. One mechanism would be to fund the corporation with a maximum amount of debt. These thin capitalization rules restrict the interest deduction to the corporation if its debt to such non-residents exceeds two times a computation of capital Subsection 18(2). Subsection 18(4). This is commonly referred to as the "thin capitalization rules".

17 These rules may be avoided if the non-resident conducts the business in Canada through a partnership. A loan made to the partnership would not be subject to the thin capitalization rules, a position acknowledged by CRA. 37 Thus, a partnership can be capitalized with 100% debt. CRA may wish to review the transaction in light of the general anti-avoidance rules ( GAAR ) to determine if the structure is governed by GAAR. 38 (d) Investment tax credits earned by a partnership flow-through to partners in proportion to their partnership interest. 39 The allocation of investment tax credits must be considered reasonable with respect to the taxpayer's partnership interest. (e) A person who is a "limited partner" of a partnership may be precluded from deducting in computing income 100% of its partnership loss by application of the limited partnership loss rules contained in subsection 96(2.1) and following. A limited partner is defined in subsection 96(2.4) to include not only a partner who is a limited partner under partnership law but a partner who receives or is entitled to receive any amount or benefit which is granted for the purpose of reducing the impact of any loss that the taxpayer may sustain by being a partner. The amount of losses to which a limited partner would be entitled to deduct in computing income are restricted to the taxpayer's at-risk amount less certain amounts relating to investment tax credits and resource expenses. The at-risk amount is defined in subsection 96(2.2) to include the taxpayer's adjusted cost base in the partnership and is reduced principally by the amount of any benefit. 37 Revenue Canada Round Table, in Report of Proceedings of the 50th Tax Conference, 1998 Conference Report (Toronto: CTF, 1999) 52:1-32 Question 1 at 52:14 updating a similar position taken at the 1992 annual conference, this notwithstanding the contrary position of the Ontario General Division in Wildenberg Holdings Limited v. MNR, 98 DTC CRA did indicate that it would follow the Ontario decision in situations where a partner's role was contractually limited. 38 The 2000 Federal Budget papers indicated that consultations would be initiated on the extension of the then capitalization rules to this kind of arrangement. To-date, there have been no further developments. 39 Subsection 127(8). Note that subsection 127(8) applies to partnerships generally. Subsections 127(8.1) through (8.5) apply to determine the investment tax credits available to a limited partner of a partnership. Investment tax credits are subject to the at-risk amount of the partners and may not be fully attributable to a limited partner.

18 Partnership Year-End The definition of fiscal period requires that a partnership taxation year end on December 31 if in a particular fiscal period a member of the partnership includes (a) an individual (other than a testamentary trust or individual exempt from tax), (b) a "professional corporation". A professional corporation is defined in subsection 248(1) to mean a corporation that carries on the professional practice of an accountant, dentist, lawyer, doctor, veterinarian or chiropractor, or (c) a partnership which includes such an individual or professional corporation. This same provision requires a professional corporation to end its fiscal period on December 31 if it is a member of a partnership that is required to end its fiscal period on December 31. Thus, a professional corporation that is not a member of any such partnerships can end its fiscal period at any time in the calendar year. Partnerships which carry on a business outside Canada, or carry on a prescribed business (none are prescribed to date) can adopt a fiscal period which ends other than on December 31 even if an individual, professional corporation or partnership is a member during the fiscal period. Since not all partnerships are subject to the requirement to adopt December 31 as the end of the fiscal period, there are a number of observations and comments: (a) The fiscal period of a law, accounting or engineering partnership consisting of individuals must end on December 31. A law or accounting partnership consisting of professional corporations also must adopt a December 31 fiscal period end. However, an engineering partnership consisting of corporations can adopt a fiscal period which terminates at any time, since a professional corporation does not include the carrying on of an engineering or architectural practice.

19 (b) A partnership owning real estate must adopt a December 31 year-end if, at any time in the year, an individual is a partner, irrespective of the percentage ownership of partnership interest. If, during the fiscal period, the individual's interest is purchased, the end of the fiscal period following can be other than on December 31 although, pursuant to subsection 249.1(7), consent of the Minister is required. (c) If a partnership whose partners include an individual owns a rental property outside of Canada, can its fiscal period end other than on December 31? The rules do not require a partnership the business of which is carried on outside of Canada to adopt a fiscal December 31 year-end. However, does the ownership of rental property by a partnership constitute a business automatically (remember a partnership must carry on a business to exist)? Jurisprudence suggests that almost any activity of a corporation constitutes the carrying on of a business. 40 Should this concept also extend to a partnership based on the requirement that it carry on a business. (d) A partnership consisting of corporate entities (other than professional corporations) still is entitled to end its fiscal period on any day in the calendar year. 40 Canada Trustco Mortgage Corporation v. MNR, 91 DTC 1313 (T.C.C.). See also The Queen v. M.R.T. Investments Ltd., 76 DTC 6158 (F.C.A.).

20 Avoidance Rules The Act contains rules that apply if members of a partnership agree to share any income or loss or any amount that is relevant in the computation of the income or taxable income of the members, and the principal reason for the agreement is to reduce or postpone tax that would otherwise be payable under the Act. In such a case, the share of each member in the income or loss or the amount, as the case may be, will be adjusted to be reasonable having regard to all circumstances including the proportions in which members agree to share profits or losses of the partnership. The purpose of the first provision, subsection 103(1), for example is to preclude partnerships which include non-taxable entities from allocating capital cost allowance and other deductions to taxable entities since the non-taxable entities do not need such deductions. Furthermore, two or more members of a partnership not dealing at arm's length with each other must share income in a manner that is reasonable in the circumstances having regard to the capital invested in or the work performed for the partnership by the members as required by subsection 103(1.1). Partners whose adjusted cost base becomes a negative amount generally are not subject to income tax on this amount. 41 This provision will not apply to the negative adjusted cost base of "limited partners". Subsection 40(3.1) deems this negative amount to be a capital gain in the year. Generally, taxpayers may not create a loss or increase a loss by claiming capital cost allowance in respect of either rental property 42 or leasing property. 43 A rental property is defined in Regulation 1100(14) to mean a building or leasehold interest in real property which is used principally for the purpose of gaining or producing gross revenue that is rent. Leasing property essentially includes depreciable property, except rental property, where the principal use is to 41 Subsection 40(3). The rule which deems a gain to arise where there is a negative adjusted cost base is not applicable to partnerships generally Regulation 1100(11). Regulation 1100(15).

21 obtain gross revenue that is a rent, royalty or leasing revenue. 44 The rules in each instance do not apply to certain corporations and to partnerships all of whose members are such qualifying corporations. 45 Corporations that are not required to restrict their capital cost allowance claims in respect of rental property or leasing property must ensure that, in entering into a partnership relationship, all other partners meet the same tests. Small Business Deduction Rules preclude the multiplication of the small business deduction through the use of corporate partnerships. 46 In computing the amount in respect of which a CCPC is eligible to claim the small business deduction, the provision permits the inclusion of the specified partnership income of the corporation. This requires a proration of income eligible for the small business deduction amongst the partners proportionate to their partnership interest. Thus, if there are two equal partners, each corporate partner would include a maximum of $250,000 in its computation of income eligible for the small business deduction. A corporation that is a member of a partnership controlled, directly or indirectly in any manner whatever, by one or more non-resident persons, one or more public corporations (other than a prescribed venture capital corporation) or by a combination thereof is precluded from including in computing income eligible for the small business deduction any share of income from that partnership. Subsection 125(6.2) deems specified partnership income of a corporation to be nil in such circumstances. Control for these purposes is determined by the percentage of income. 47 A partnership is deemed controlled by a person or persons whose share of income exceeds 50% of partnership income for the year. This precludes a CCPC which would be a minority shareholder of a corporation that would not have qualified as a CCPC from structuring the business vehicle as a partnership to obtain benefits of the small business deduction Regulation 1100(17). Regulations 1100(12) and 1100(16) respectively. Subsection 125(1) and the reference to specified partnership income. Subsection 125(6.3).

22 Where a corporation which has claimed the maximum small business deduction wishes to enter into a new business in which it would be the majority holder, consideration might be given to using a partnership to carry on the business in contrast to a corporation. This would entitle the minority partner to obtain the benefit of the small business deduction with respect to its share of specified partnership income. Consider the following example: ACO which already earns more than $500,000 of active business income in a year will become a 60% holder of a new business with BCO which will hold the remaining 40% and will have no other active business income. It is expected that the new business will earn $500,000 per annum. If the business were to be incorporated, ACO BCO NEWCO ACO would be associated with Newco 48 and Newco would not be entitled to any further small business deduction. Contrast this with the establishment of a partnership to hold the business interest. 48 Paragraph 256(1)(a) deems one corporation to be associated with another if it is controlled, directly or indirectly, in any manner whatever, by the other. Furthermore, one corporation is deemed to control another by virtue of paragraph 256(1.2)(c) if one corporation holds more than 50% of the fair market value of all of the issued and outstanding common shares of the other corporation.

23 ACO BCO PARTNERSHIP Although ACO would not be able to increase its utilisation of the small business deduction, BCO's specified partnership income would be $200,000 (40% of $500,000) and it would be entitled to the small business deduction. Provincial Allocation of Income Persons who are a member of a partnership are considered to have a permanent establishment in each jurisdiction in which the partnership has a permanent establishment. 49 Each partner of a partnership which has a permanent establishment in a province is required to allocate income to each such province, to file income tax returns with those provinces where returns are necessary 50 and to allocate in respect of its federal income tax return income to the other provinces and territories pursuant to the allocation therein. Income is allocated to a province by multiplying 50% of the aggregate of (i) gross revenue attributable to each permanent establishment in a province, and (ii) salaries and wages attributable to the permanent establishment in each province. 51 The following illustrates this procedure. Assume: 49 See No. 60 v. MNR (T.A.B.), 59 DTC These include the provinces of Quebec, Alberta and British Columbia for corporations and Quebec for individuals. 51 Regulation 402 to the Act, and part IV of the Regulations.

24 (a) the partnership's taxable income is $1 million, (b) gross revenue is $10 million, $4 million attributable to province No. 1 and $6 million attributable to province No. 2, (c) aggregate salary and wages is $6 million, $3 million attributable to each province. Taxable income attributed to province No. 1 will be equal to 50% X ($ 4,000,000 + $ 3,000,000) ($10,000,000 $ 6,000,000), or X 50% (40% + 50%), or 45% or $450,000 of $1,000,000 The calculation of a corporation's gross revenue, and salaries and wages paid in the year includes its share of partnership gross revenue, and partnership salaries and wages paid, proportionate to its share of the income or loss of the partnership. 52 Partnership Property Transfers Similar to corporations, it is possible to transfer property to a partnership without incurring any income tax liability by utilising the election provisions contained in sections 97 and 98. There are a number of distinctions with regard to the rules pertaining to the tax-free transfer of assets to a corporation and to a partnership, some of which are summarized below: 52 Regulation 406. Most provinces follow the federal computation in determining taxable income earned in a province. See, for example, section 6(3) of the Income Tax Act (Saskatchewan), RSS 1978, c. I-2, as amended. The provinces of Ontario and Quebec calculate taxable income earned in a province in accordance with their respective tax legislations although the calculation is substantially identical to that contained in the Act.

25 (a) A tax-free transfer of an interest in real property that is inventory may not be transferred to a corporation under subsection 85(1) since such property is not eligible property. 53 Real estate inventory may be transferred to a Canadian partnership since all forms of inventory may be transferred tax-free to a partnership. 54 CRA has indicated, however, that where parties elect to transfer real estate inventory to a partnership with a view to ultimately transferring that inventory to a corporation, it may elect to use the GAAR provision to attack such a transaction. 55 (b) Tax-free transfers are permitted to all taxable Canadian corporations including those controlled by non-residents. Transfers to a partnership must be to a Canadian partnership, defined in subsection 102(1) to mean a partnership all of the members of which were resident in Canada at the time. In contemplating the establishment of a new business with one or more non-resident persons, consideration must be given to the potential taxation of accrued gains on properties which would be transferred to that new business vehicle if it is a partnership. It may be necessary to structure the timing of admission of non-resident partners. If non-residents are to be partners, they should join after the transfer of property. A transfer is eligible for rollover treatment if, immediately after the transfer, the partnership is a Canadian partnership. (c) Where a corporation wishes to distribute property to one or more or all of its shareholders, it must abide by the butterfly provisions of section 55. The rules pertaining to the transfer of property by a partnership to its partners are in some ways simpler and in some ways more complex than the butterfly provisions applicable to a corporation See the definition of eligible property in subsection 85(2.1) which excludes real estate inventory. Subsection 97(2). Information Circular IC 88-2, paragraph 12.

26 (i) In the first instance, each partnership property must be distributed in undivided interest to each partner, proportionate to its interest in the partnership. 56 In a butterfly transaction, a shareholder may receive one property and not another property provided that the proportionality tests set out in paragraph 55(3)(b) are met. (ii) All taxable Canadian corporations may undertake butterfly transactions. Only Canadian partnerships may make tax-free distributions. Partnerships with non-resident shareholders, therefore, may not avail themselves of the provisions of subsection 98(3). (iii) Section 55 effectively precludes dispositions that are part of the series of transactions that include the butterfly. Subsection 98(3) contains no such restrictions. Partnership Estate Freeze Unlike a corporation, using a partnership as an estate freeze vehicle may not be effective where the freeze is in respect of an existing business. Assume a parent holds an interest in a corporation. The estate freeze can be accomplished through a corporate structure by creating a new corporation ( Newco ), by causing the parent to transfer the shares of the target corporation to Newco in exchange for preferred shares and by issuing common shares of Newco to the children or a trust created for their benefit. No obligation exists to pay dividends to the parent in respect of the preferred shares issued. If a partnership was used for an estate freeze to avoid a capital tax liability which would otherwise arise in using a corporation, the partnership would issue to the parent, in exchange for the asset transferred, a non-participating interest in the partnership. It would be open to CRA to challenge the failure to allocate income to the parent in respect of its interest pursuant to subsection 103(1.1). 56 Subsection 98(3).

27 Flow-Through Issues CRA appears to have an occasional inconsistent treatment when it comes to the flow-through of certain taxation elements to partners. (a) CRA is of view that the term "taxpayer" applies to a partnership when that term is relevant to the computation of income, since paragraph 96(1)(a) requires the partnership to compute income as if it were a separate person resident in Canada. This view does not necessarily extend to the use of the word "taxpayer" in respect of income tax credits and the levying of income tax. (b) Paragraph 96(1)(f) deems a source of income of the partnership to be that of the partners. Partners of a partnership which receive taxable dividends and capital dividends are considered to have received their respective share. 57 (c) For the purposes of determining part IV tax, subsection 186(6) deems taxable dividends received by a partnership to be received by each member of the partnership and deems each member of the partnership to own shares of the corporate payer proportionate to its share of dividends received from the partnership. But for this provision, presumably a corporate payer of dividends would not be connected with a corporate partner of a partnership that received dividends. The technical notes indicated that this amendment to the Act simply was for clarification. CRA s administrative position at the time was identical to this amendment. This position implied that each corporate partner of a partnership owned shares of any corporation held by the partnership proportionate to its interest therein. 57 Interpretation Bulletin IT-138R, paragraphs 4 and 5.

28 (d) Subsection 112(1) permits a corporation to deduct in computing taxable income taxable dividends received from taxable Canadian corporations. CRA acknowledges that this provision applies in respect of dividends received by a partnership and allocated to corporate partners. The distinction between subsections 112(1) and 113(1) upon which CRA had relied is the reference to the word received in subsection 112(1) in contrast to the word owned in subsection 113(1). It should be noted, however, that section 96 only deals with the computation of income and not the computation of taxable income and that this cannot be the basis for CRA's position. (e) Subsection 112(3) exists to preclude corporations from claiming capital losses in certain circumstances where the corporation has received various dividends in respect of a share. The provision applies with respect to corporate ownership of shares. Subsections 112(3.1) and (3.2) were added to ensure identical rules applied to a corporate member of a partnership or to a beneficiary of the trust. Presumably, the Department of Finance felt the need to introduce these provisions because it had concluded that a corporate partner would not be considered to own shares of a corporation held by the partnership. (f) CRA is of the view that an interest in a partnership is not considered an interest in its underlying assets for the purposes of section 85. Nevertheless, for the purposes of determining whether or not a corporation is a small business corporation, CRA considers that the corporation may look at the underlying partnership assets to determine whether or not it meets the tests. (g) CRA is of the opinion that where a business is carried on by a partnership, each partner is considered to employ the employees of the partnership. This is important, for example, in determining whether or not a corporation has or has no income from a specified investment business.