Principal Issues: [TaxInterpretations translation] Would the provisions of subsection 103(1) apply in respect of the allocation, between 2 of the limited partners, of income earned by a limited partnership?
Position: None
Reasons: Question of fact
XXXXXXXXXX 2006-017007
October 30, 2006
Dear Sir,
Subject: Request for Technical Interpretation --Application of Sections 97(2) and 103(1) of the Income Tax Act
This is further to your letter dated February 6, 2006, requesting the interpretation of the Canada Revenue Agency ("CRA") regarding the allocation between limited partners of income earned by a limited partnership in the circumstances described below.
Unless otherwise indicated, all statutory references herein are to provisions of the Income Tax Act ("Act").
Facts
The stated facts are as follows:
1. A limited partnership ("LP") has issued various units to different limited partners.
2. Usually, each limited partner is allocated a share in the net taxable income of the LP in proportion to the number of units held.
3. The limited partners include two corporate partners ("Corporation 1 and Corporation 2").
4. Under the terms of the limited partnership agreement, the business of the LP is to acquire, own and operate real estate.
5. Corporation 1 and Corporation 2 owned a building that was transferred to the LP.
6. Corporation 1 and Corporation 2 transferred the building to the LP by way of a tax rollover in accordance with the provisions of section 97.
7. At that time, the building had a fair market value ("FMV") of $4 million and an undepreciated capital cost ("UCC") of $3 million.
8. The T2059 rollover form indicates that the agreed amount for the building transfer was $3 million.
9. After that rollover, Corporation 1 and Corporation 2 received the sum of $4 million as a capital withdrawal.
10. As a result of that rollover, the tax consequences (capital gain and recapture of depreciation) were not recognized but rather deferred until the building was sold.
11. As part of that transaction, Corporation 1 and Corporation 2 agreed to assume the full amount of taxes arising from the existing tax effects at the date of the rollover, which was $1 million.
12. Since the acquisition of the building, the LP has claimed capital cost allowance based on the UCC of $3 million rather than the price paid of $4 million.
13. The transfer of the building therefore benefited Corporation 1 and Corporation 2 to the detriment of the LP, which could not benefit from increased depreciation expense resulting from the price paid.
14. In early 2006, the LP received an offer to sell its building for $3.5 million.
15. At the time of sale, the building had an UCC of $2.8 million.
16. In 2006, taking into account the $700,000 recapture of depreciation, LP expects to realize a net tax benefit of approximately $500,000, as current operations will generate an operating loss of $200,000.
Questions
The question concerns the proposed allocation of income. You mention that the LP's net income is usually allocated in proportion to the number of units held by each limited partner. However, for 2006, the LP wishes to allocate all of the estimated net tax revenue of $500,000 to Partnership 1 and Partnership 2 and nothing to all other limited partners.
In view of the above, the LP would like to know whether this allocation of income appears to be acceptable and would like to receive confirmation from the CRA that it will not result in the application of the anti-avoidance rule in section 103.
Our Comments
As stated in paragraph 22 of Information Circular 70-6R5 dated May 17, 2002, it is the practice of our Directorate not to issue written opinions on proposed transactions otherwise than by way of advance rulings. Furthermore, when it comes to determining whether a completed transaction has received appropriate tax treatment, that determination is made first by our Tax Services Offices as a result of their review of all facts and documents, which is usually performed as part of an audit engagement. However, we can offer the following general comments which may not apply in full to the situation you have submitted to us.
For the purposes of this letter, we have assumed that the LP is legally constituted. We have also assumed that contracts and agreements exist, are valid and comply with applicable law. We have assumed that proper written agreements are in place.
Generally, all income and losses of an LP are allocated in proportion to the number of units held by each limited partner. However, there may be special circumstances where the allocation would be different and would still be considered reasonable. (See in particular Technical Interpretations F2003-0029571E5, F2001-0070815).
The question you raise is essentially a question of fact which we cannot answer definitively without examining all the circumstances surrounding your particular situation. Such an examination is not undertaken in the context of a request for a technical interpretation. Therefore, we cannot confirm whether section 103 applies to this situation.
However, as a general comment, in the situation you described, there are two points to consider. On the one hand, all the profits are allocated to the two partners, which may or may not be considered an excessive allocation to them. On the other hand, the fact that the profit is less than the gain on the disposition of the building implies that the other limited partners have absorbed some of the gain: otherwise they would have been allocated a $200,000 loss that they could have deducted from their other sources of income. This could represent an unreasonable transfer of income from these two limited partners (who report $500,000 instead of $700,000) to the other limited partners.
Finally, in light of the information we have on the present situation, we can indicate that the possible sharing, as described in your letter, seems reasonable on its face, although we do not have enough information to determine whether the main purpose of the income sharing is to reduce taxes or to defer the payment of taxes and whether the allocation of income should be modified under subsection 103(1). However, we are still of the view that this is a question of fact on which we are not issuing a ruling and which will have to be examined by the Tax Services Office in an audit to determine whether section 103(1) applies.
These comments are not advance income tax rulings and do not bind the Canada Revenue Agency with respect to any particular factual situation.
We hope that these comments are of assistance.
Finally, we regret the delay in responding to your request. Please accept our apologies.
Best regards,
Phil Jolie
Director
Business and Partnerships Division
Income Tax Rulings Directorate