Canada: Tax Trap For Canadian Partnerships: The CRA Can Reallocate A Taxpayer's Income From A Partnership If The Agreed-Upon Allocation Doesn't Reflect Capital Contributions To The Partnership – Aquilini Et Al. V The Queen, 2021 FCA 206 – A Canadian Tax Lawyer's Analysis

Introduction: Canadian Partnerships & the Income-Reallocation Rule under Subsection 103(1.1) of Canada's Income Tax Act

A partnership is a group of two or more persons who run a business together. Ontario's Partnership Act codifies the common law and defines a partnership as "the relation that subsists between persons carrying on a business in common with a view to profit." Hence, a partnership is simply the relationship among its members. Unlike a sole proprietorship, a partnership has at least two members. Yet a partnership is like a sole proprietorship in that the partners directly carry on the business themselves. Unlike a corporation, which gives rise to a legal personality separate from its shareholders, a partnership does not comprise an entity separate from its members. So, with a partnership, while the partnership's name may appear as the party to a contract between the partnership and, say, a vendor or client, that name doesn't refer to a separate legal person; it essentially denotes the relationship between the partners comprising the partnership. As such, the partners themselves become jointly and severally liable for any partnership liabilities under that contract.

You can, of course, limit the potential personal liability by forming a partnership in which the partners consist of two or more corporations. And provincial law allows partners to register as a "limited partnership," which serves to limit the liability of silent partners-i.e., those without any management or control over the business. Professionals-such as accountants, lawyers, and doctors-can also register as a "limited liability partnership" or "LLP," which insulates one partner from liability resulting from the professional negligence of another. Still, while these arrangements serve to limit the partners' exposure to liability, they don't alter the nature of the partnership itself. That is, the partnership remains nothing more than a relationship between its members and doesn't constitute a distinct legal person.

Although Canada's Income Tax Act hypothetically treats a partnership as a separate person, it does so only for income-calculation purposes. In particular, computing a taxpayer's taxable income from a partnership entails a two-step process. You first compute the income at the partnership level. To that end, under subsection 96(1) of the Income Tax Act, the partnership's taxable income is calculated "as if the partnership were a separate person." This calls for the calculation of the partnership's business profits (or business loss), its net investment income (or investment losses), and its net taxable capital gains (or allowable capital losses).

You then compute each partner's taxable income from the partnership. Specifically, after you determine the overall income or loss at the partnership level, you then allocate that income or loss to each partner in accordance with that partner's entitlement to the partnership's proceeds or losses. The allocated income or loss also retains its character. For example, a dividend earned by the notional partnership will remain a dividend when allocated to the partner, an allowable capital loss in the hands of the notional partnership remains an allowable capital loss when allocated to the partner, and so forth. This means that the partner's allocation of the partnership income will retain its tax attributes. For example, a partner can claim a dividend tax credit on the partner's share of any dividends that the partnership received from a taxable Canadian corporation. Likewise, the partner cannot use its allocation of the allowable capital loss to offset any source of income other than a capital gain realized by that partner.

The partners themselves will typically agree upon their entitlement to the partnership's proceeds or losses by way of a written partnership agreement. Unsurprisingly, partners may seek an allocation that minimizes their tax burdens. The partners might, for instance, agree to allocate a larger share of the partnership income to a partner with loss carryovers, tax credits, or other amounts allowing that partner to shelter the income from tax. These tax-avoidance arrangements most often involve partnerships between related parties-i.e., partners who don't deal with each other on arm's-length terms.

Yet Canada's Income Tax Act contains tax rules designed to thwart these tax-avoidance arrangements by Canadian partnerships. In particular, subsection 103(1.1) allows the Canada Revenue Agency to reallocate each partner's share of the partnership income or loss if the CRA determines that the partners adopted an unreasonable allocation. Most recently, the CRA successfully invoked the subsection 103(1.1) income-reallocation rule in Aquilini et al. v The Queen, 2021 FCA 206. In Aquilini, the Federal Court of Appeal affirmed the CRA's decision to increase four partners' income by about $38 million because the original allocation failed to reflect the partners' contributions to the partnership.

After analyzing the Canadian partnership income-reallocation rule under subsection 103(1.1) of Canada's Income Tax Act, this article examines the Federal Court of Appeal's decision in Aquilini. We conclude the article by offering pro tax tips and expert Canadian tax lawyer guidance on disputing a CRA tax reassessment of your income from a partnership.

The Income-Reallocation Rule for Canadian Partnerships Involving Related Members: Subsection 103(1.1) of Canada's Income Tax Act

Subsection 103(1.1) applies if two conditions have been satisfied: (1) the members of a partnership don't deal with each other on arm's-length terms; and (2) those members agree to an unreasonable allocation of the partnership's income or loss among them.

If it applies, the rule deems each member's allocation of the partnership's income or loss to be "the amount that is reasonable in the circumstances." In other words, subsection 103(1.1) empowers the Canada Revenue Agency to impose its own allocation upon the partnership's members.

Subsection 103(1.1) applies only if the partners agree to an allocation that "is not reasonable in the circumstances." And if the rule applies, the CRA's own allocation must be "reasonableness in the circumstances." The provision specifies that the reasonableness of the allocation is determined by considering the following factors: (i) the capital invested in the partnership by its members; (ii) the work performed for the partnership by its members; and (iii) "such other factors as may be relevant."

In addition, the income-reallocation rule applies only if the partnership's members deal on non-arm's-length terms. The Income Tax Act deems related taxpayers (e.g., spouses, corporation/majority shareholder, trust/beneficiary) to deal on non-arm's-length terms. So, subsection 103(1.1) may apply to partnerships involving those taxpayers. Yet the surrounding facts and circumstances ultimately determine whether parties deal with each other on arm's-length terms. This means that subsection 103(1.1) may also apply to a partnership involving taxpayers who aren't otherwise related. To discern whether a parties deal with each other at arm's length, courts look at three criteria: (1) whether a common mind directed the bargaining for both parties; (2) whether the parties acted in concert without separate interests; and (3) whether any party could exercise de facto control, influence, or authority over the other. In addition, after applying these three tests, a court may also test the soundness of the overall result by considering whether the transaction terms reflected "ordinary commercial dealings." (R. v. Remai Estate, [2010] 2 CTC 120, 2009 DTC 5188 (FCA), at para 34.) This means that a transaction involving below-market-value consideration may by itself suffice to show that the parties dealt on non-arm's-length terms. In the context of subsection 103(1.1), it means a that a partnership allocation failing to reflect the members' capital or labour contributions may suggest a non-arm's-length partnership.

Partners Contribute 0.0006% Yet Receive 99% Income Allocation: Aquilini et al. v The Queen, 2021 FCA 206

The Aquilini family runs a real-estate portfolio. In 2001, the family consolidated their business interests under a single limited partnership, the Aquilini Investment Group Limited Partnership ("AIGLP"). AIGLP consisted of several partners, including Elisa Aquilini; her three sons Francesco, Roberto, and Paolo; and four family trusts.

The partners of AIGLP allocated the partnership's income in accordance with the type and number of partnership units held by each partner. In particular, the first $1 million would be allocated to the units held by Elisa and her three sons. Any income over $1 million would only be allocated to the partnership units held by the four family trusts.

To acquire their partnership units in AIGLP, the four family trusts contributed a combined total of $1,000. The other partners contributed total capital in excess of $150 million.

AIGLP sought to purchase the Vancouver Canucks hockey team. To finance a portion of the purchase price, the partnership sold various properties in 2007. The sale resulted in a total taxable capital gain of about $48 million.

Of the $48 million that AIGLP earned in 2007, about 99% was allocated to the four family trusts, and the remaining 1%-about $513,000-was allocated to AIGLP's other partners, including Elisa and her three sons. Thus, for the 2007 tax year, Elisa reported her net income from AIGLP as just over $176,000, and her three sons each reported about $50,000 in net income from AIGLP.

The Canada Revenue Agency decided that the AIGLP partners had adopted an unreasonable allocation of the partnership's net income. As a result, the CRA reassessed Elisa and her three sons under subsection 103(1.1)-increasing Elisa's share of AIGLP's net income from $176,000 to $4.2 million and increasing each son's share of AIGLP's net income from $50,000 to $11.5 million. The CRA also reassessed the four family trusts and proportionately reduced their reported income from AIGLP.

The professional Canadian tax litigation lawyers for Elisa and her three sons objected to the CRA's reallocation of their partnership income. The dispute eventually reached the Tax Court of Canada. The court sided with the Canada Revenue Agency. The court reasoned that the income allocation to the four family trusts failed to reflect their capital contribution or the work that they performed. The court also reasoned that, if AIGLP had been composed of arm's-length partners, they would not have adopted the same allocation of the partnership's net income. The taxpayers argued that their creditor-proofing goals and estate-planning goals qualified as "such other factors as may be relevant" to determining the reasonableness of the allocation. The court disagreed, finding that "reasonable arm's length business people acting in their own interests as owners of such partnership units would not consider as relevant the personal creditor proofing or estate planning goals of the Appellants." As a result, the court concluded that the allocation of AIGLP's income to the family trusts was unreasonable and dismissed the taxpayers' appeal.

The taxpayers appealed the Tax Court's decision and brought the dispute to the Federal Court of Appeal. In particular, the taxpayers argued that the Tax Court of Canada had erred by (i) considering whether arm's-length partners would have allocated AIGLP's net income the same way, (ii) finding that creditor protection didn't motivate the income allocation, and (iii) concluding that creditor protection wasn't a relevant factor to determining the reasonableness of the allocation.

The Federal Court of Appeal rejected all three arguments. The appellate court endorsed the Tax Court's interpretation of subsection 103(1.1). The taxpayers maintained that, because subsection 103(1.1) only applies to non-arm's-length partners, the Tax Court erred by considering what arm's-length partners would have done. The appellate court disagreed, pointing out that the factors relevant to determining reasonableness "cannot simply be the factors that partners who are not dealing with each other at arm's length would consider relevant. Otherwise, the provision would never have any application as any allocation of income could be justified by non-arm's-length partners based on factors that such partners consider relevant. Rather, the question is what factors Parliament intended to include as 'such other factors as may be relevant.' [.] A particular factor that would be used to allocate income to partners dealing with each other at arm's length should therefore be considered to be a relevant factor for the purposes of subsection 103(1.1) of the [Income Tax Act]."

The appellate court also refused to overturn the Tax Court's factual finding that creditor protection didn't motivate the income allocation. No appellate court will interfere with a trial judge's findings of fact unless an appellant demonstrates that the trial judge made a "palpable and overriding error." In plain language, this means that an appellate court will rarely contest a trial judge's factual findings. This is because the trial judge benefits from first-hand observation of the evidence, including witness testimony and cross-examination. The taxpayers failed to show that the Tax Court committed a "palpable and overriding error" when concluding that creditor protection didn't motivate the income allocation. So, the appellate court upheld the finding.

Finally, the Federal Court of Appeal agreed with the Tax Court's conclusion that creditor protection wasn't a relevant factor to determining the reasonableness of the allocation. The taxpayers claimed that they allocated AIGLP's income to the four family trusts to protect assets from claims by the individual partner's ex-spouses. Yet the appellate court observed that the creditor-protection purpose wasn't related to anything that allowed AIGLP to earn that income. "Creditor protection," reasoned the court, "is not of the same class as the enumerated factors of capital invested and work performed, both of which are factors that would have, directly or indirectly, led to or contributed to the income that was earned by the partnership and which is allocated to the partners." As a result, the Federal Court of Appeal upheld the Tax Court's decision, concluded that the allocation of AIGLP's income was unreasonable, and dismissed the taxpayers' appeal.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.