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Partnerships are frequently used in various legal structures as they can be a beneficial vehicle to address certain business needs. Despite the advantages of using a partnership, partners must nevertheless take into account the potential taxation issues that may arise.
A partnership is not taxed as a separate entity. Under subsection 96(1) of the Income Tax Act (the “ITA”), the income or losses of a partnership are first computed as if the partnership is a separate person and are thereafter allocated to the partners.[1]
The partnership agreement will usually provide for a mechanism for the allocation of income and losses between the partners. It is important for partnerships to consider subsections 103(1) and 103(1.1) of the ITA when allocating income or losses to partners. More specifically, pursuant to subsections 103(1) and 103(1.1) of the ITA, the tax authorities have the ability, in certain circumstances, to reallocate income or losses amongst the partners. In the event of a successful adjustment by the tax authorities, the partners could be subject to significant unintended tax consequences.
Subsection 103(1) of the ITA – The purpose test
Where partners have agreed to share income and losses of a partnership in a certain way and the tax authorities determine that the principal reason for that agreement is the reduction or postponement of tax that might otherwise be payable, subsection 103(1) of the ITA allows the tax authorities to reallocate the income and losses of the partnership between the partners to an amount that is reasonable.
Unlike subsection 103(1.1) of the ITA (described below), subsection 103(1) may apply even if the partners of the partnership are dealing at arm’s length. This purpose test has been interpreted by the courts in a strict manner such that the application of subsection 103(1) of the ITA does not necessarily require that there be an overall reduction or postponement of tax or that the reduction or postponement of tax accrues to the benefit of any particular partner. If the principal reason is to reduce one taxpayer’s tax, it is sufficient for subsection 103(1) of the ITA to apply.[2] For example, in certain circumstances, should an allocation method merely displace tax consequences from a partner, an individual, to another, a trust, an entity that could be taxable at the highest marginal tax rate, there nonetheless exists a tax reduction in regards to the individual and accordingly, the application of subsection 103(1) ITA could be triggered.
Subsection 103(1.1) of the ITA – The reasonableness test
Where two or more partners who are not dealing at arm’s length agree to share income and losses of a partnership in a certain way and the tax authorities determine that the allocation is unreasonable in the circumstances having regard to the capital invested in the partnership, the work performed or ‘’such other factors as may be relevant’’, subsection 103(1.1) of the ITA allows the tax authorities to reallocate the income and losses between the partners to an amount deemed reasonable in the circumstances.
To determine the “reasonableness” of the allocation regard must be had to capital invested in or work performed in the partnership, two mandatory factors to consider, or other relevant factors. For instance, allocating the vast majority of a partnership’s income to one or more partners who did not contribute significant capital or perform much of the work may lead to the allocation being considered to be unreasonable.
Furthermore, an objective test is applied for the purpose of determining, “such other factors as may be relevant”.[3] Whether a factor may be relevant depends on whether reasonable arm’s length business people acting in their own interests as partners would consider such factor to be relevant.[4] The courts have recently confirmed that personal creditor protection and estate planning goals are not relevant factors for the purposes of subsection 103(1.1) because they are personal factors incompatible with the objective test provided under subsection 103(1.1) of the ITA.[5]
To conclude, the goal of subsections 103(1) and 103(1.1) of the ITA is to address profit and loss shifting using partnerships by giving the tax authorities the ability to reallocate partnership income or losses in certain circumstances. A case-specific analysis is required to determine whether the tax authorities could seek to apply subsections 103(1) or 103(1.1) of the ITA in respect of a particular partnership allocation. Contact a member of the Miller Thomson LLP Corporate Tax team if you have any questions or concerns regarding partnership taxation.
[1] Subsection 96(1) of the Income Tax Act (the ‘’ITA’’).
[2] Penn West Petroleum Ltd. v. Canada, 2007 TCC 190 , par. 45 and Aquilini v. Canada, 2019 TCC 132, par. 138-140 (aff’g, 2021 FCA 206).
[3] Subsection 103(1.1) of the ITA.
[4] Aquilini v. Canada, 2021 FCA 206, par. 34.
[5] Id., par. 34 and Aquilini v. Canada, 2019 TCC 132, 98-99.
