Principal Issues: [TaxInterpretations translation] 1. Does the Canada Revenue Agency ("CRA") recognize the use of a partnership in a freeze?
2. In a situation where a father and son, who are the only equal members of a partnership, exchange, in a transaction equivalent to a corporate freeze, common units in the partnership for preferred units entitling them to a return equivalent to the return on a similar capital investment in an unrelated financial institution, and all the sons then subscribe for common units for a nominal amount, can the CRA confirm that subsection 103(1) or 103(1).(1) of the Income Tax Act (the "Act") will not apply if the allocation of profits is made first in payment of the return on the preferred units?
3. In a situation where the facts are the same as in Question 2 with the only variation being that a family trust, in which at least one of the beneficiaries is involved in the activities of the partnership, subscribes for a common unit, can the CRA confirm that subsection 103(1) or 103(1.1) will not apply?
Position: 1. Regardless of whether a partnership is used in an estate freeze, subsection 103(1) or 103(1.1) could apply if the allocation of the partnership's income does not take into account the capital and non-cash contribution of each partner.
2. No. Subsection 103(1.1) of the Act could apply.
3. Same answer as in 2, for the same reasons.
Reasons: 1. The CRA reiterates its long-standing position.
2. The mere fact that preferred units of a partnership are entitled to a return equal to the market rate of return on a similar capital investment would not in itself preclude the application of 103(1.1) of the Act.
3. Same reasons as in 2.
FEDERAL TAX ROUNDTABLE
APFF CONFERENCE 2010
Question 16
Freeze of a partnership - subsections 103(1) and 103(1.1)
In Income Tax Technical News No. 30 (footnote 1), the CRA issued its position on the creation of preferred units of a partnership. That position was reiterated in response to question 18 of the Society of Trust and Estate Practitioners 2007 Roundtable (footnote 2). That position is that:
“…there is no impediment to the creation of partnership interests that carry different entitlements to a share in the income, loss or other attributes of the partnership. However, the sharing of these tax attributes is subject to section 103 of the Act. In considering the application of section 103, we would examine whether one of the principal reasons for the separate interests was the reduction or postponement of tax, or in the case where two or more members of the partnership are not dealing with each other at arm's length, whether the amount of income or loss allocated to Taxpayer A was reasonable having regard to the circumstances, including capital invested and work performed.”
In the recent Tax Court of Canada case of Krauss v. The Queen (footnote 3), the judge stated in obiter:
"Whether an estate freeze can be effected through a partnership in the abstract does not need to be answered. I believe that to the extent an estate freeze can be effected through a corporate vehicle, if the same economics can be replicated through a partnership, that an estate freeze could be effected through a partnership."
Questions to the CRA
(a) Following this clarification by Justice McArthur, where the circumstances do not differ from an acceptable corporate freeze, can the CRA confirm that an estate freeze of a partnership would be possible?
(b) Consider a situation where a father and son are partners in a 50/50 partnership, a freeze of the father's and son’s interests is achieved in a manner equivalent to a corporate freeze, i.e., by issuing, to each, preferred units entitling them to an annual return equivalent to the return that would be earned on a similar capital investment in an unrelated financial institution, and subsequently, his sons subscribe for common units of the partnership for a nominal amount. The allocation of the partnership's profit will be made first in payment of the return on the preferred interests and the balance of the profit will be allocated to the sons. Can the CRA confirm that, given that this estate freeze is analogous to a corporate estate freeze, the allocation of the partnership's profit among the partners is reasonable and, therefore, would not trigger the application of subsections 103(1) and 103(1.1)?
(c) Would the CRA's answer be the same if a family trust, in which at least one of the beneficiaries is involved in the activities of the partnership, subscribes for a common unit, with the same assumptions for allocating the partnership's profit applying?
CRA's Response to Question 16(a)
The CRA reiterates its position issued in response to Roundtable Question 18 at the Society of Trust and Estate Practitioners - Canada Annual Conference and maintains that regardless of whether a partnership is used in an estate freeze, the allocation of partnership income must recognize the capital contribution, as well as the non-cash contribution of each partner. Otherwise, subsections 103(1) or 103(1.1) could apply to modify the allocation of the partnership's income, loss or other partnership attributes provided for in the partnership agreement. In our view, the Krauss case supports that position.
CRA's Response to Question 16(b)
It appears to us that your example is similar to the situation in Krauss and that subsection 103(1.1) could apply in your example.
CRA Response to Question 16(c)
The answer to question (c) is the same as the answer to Question (b).
Lucie Allaire
(613) 957-2046
October 8, 2010
2010-037336.
FOOTNOTES
Due to our system requirements, footnotes contained in the original document are reproduced below:
1 CANADA REVENUE AGENCY, Income Tax Technical News No. 30, May 21, 2004, question 6.
2 "Practitioner/CRA Roundtable", in the 2007 STEP Canada National Conference, June 8, 2007, question 18.
3 2009 D.T.C. 1394 (T.C.C.)