Toronto Partnership Lawyer: Limited Partnerships (Part 5) – Tax Considerations Canada

Following up on my recent articles about Ontario limited partnerships, what they’re all about, how a limited partner can lose their limited partner status, how a limited partnership is not a separate legal person, and securities laws compliance, this article discusses certain tax considerations for limited partnerships.

Following up on my recent articles about Ontario limited partnerships, what they’re all about, how a limited partner can lose their limited partner status, how a limited partnership is not a separate legal person, and securities laws compliance, this article discusses certain tax considerations for limited partnerships.

Not a Separate Legal Entity
I have previously written about limited partnerships NOT being separate legal entities from the partners. Partnership income, losses, assets, and liabilities are all attributable to the partners. As per the Canada Income Tax Act, partnerships do not file separate tax returns. They file annual “information returns” setting out their income and details of the partners who are entitled to that income. It is the partners who are required to pay income tax. The limited partnership is simply a flow-through entity. So to recap: the net income of the partners (for income tax purposes) of a limited partnership is determined by figuring out the net income of the limited partnership.

To figure out the net income of the limited partnership, the Act says that you look at it as if it were a separate legal person: s. 96(1)(a). So you include income and deduct allowable expenses and other credits. Then, the limited partnership’s income will be attributed to the partners (usually as per the limited partnership agreement). Each partner must report their income or losses from the partnership and pay taxes accordingly: s. 96(1)(f).

It’s important to note here that the Act doesn’t just allow partners to determine the allocation of their partnership interests as they wish. There are two important restrictions here under ss. 103(1) and (1.1):

103. (1) Where the members of a partnership have agreed to share, in a specified proportion, any income or loss of the partnership from any source or from sources in a particular place, as the case may be, or any other amount in respect of any activity of the partnership that is relevant to the computation of the income or taxable income of any of the members thereof, and the principal reason for the agreement may reasonably be considered to be the reduction or postponement of the tax that might otherwise have been or become payable under this Act, the share of each member of the partnership in the income or loss, as the case may be, or in that other amount, is the amount that is reasonable having regard to all the circumstances including the proportions in which the members have agreed to share profits and losses of the partnership from other sources or from sources in other places.

(1.1) Where two or more members of a partnership who are not dealing with each other at arm’s length agree to share any income or loss of the partnership or any other amount in respect of any activity of the partnership that is relevant to the computation of the income or taxable income of those members and the share of any such member of that income, loss or other amount is not reasonable in the circumstances having regard to the capital invested in or work performed for the partnership by the members thereof or such other factors as may be relevant, that share shall, notwithstanding any agreement, be deemed to be the amount that is reasonable in the circumstances.

So basically, s. 103(1) says that, if the “principal reason” for the partnership allocation may be “reasonably considered” for the purpose of reducing or postponing tax, then the Act will re-allocate partnership interests to what is “reasonable in the circumstances”. Meanwhile s. 103(1.1) says that non-arms length persons (so it doesn’t apply to arm’s length persons) have a partnership allocation that is not “reasonable” with respect to the partners’ respective capital contributions, work performed, etc., then the Act will re-allocate partnership interests (once again) to what is “reasonable in the circumstances”.

Fiscal Year End
For tax purposes (remember that partnerships must file an annual partnership information return after their fiscal period), the combined effects of ss. 96(1) and 249.1 of the Canada Income Tax Act make it clear that the fiscal period will be determined by the type of taxpayers (e.g. individuals, corporations, etc.) that make up the partnership group. If any member of the partnership is an individual, then the fiscal year end must generally be the calendar year end (with certain limited exceptions). If all of the members of the partnership are corporations, the the fiscal year end can be anywhere, so long as the fiscal period does not exceed 53 weeks: s. 249.1(1)(a).

At Risk Rules
Generally, limited partnerships have been used as flow-through investment vehicles for the limited partners to realize and capture losses of a start-up business in its first few years. They are beneficial structures because they give investors limited liability (so long as they are limited partners) while allowing losses to be directly attributable to the partners. It’s typical to see the general partner receive a fee for managing the limited partnership while the limited partners receiving the lion’s share of flow-through income/losses.

So we start off with the idea that losses of a limited partnership are directly attributable to the limited partners in proportion to what the limited partnership agreement says. But there are exceptions to this general statement (as noted above). And there are additional limits on the extent to which limited partners can deduct these losses. The Act says that limited partners can only deduct limited partnership losses up to their “At Risk” amount at the end of the fiscal year. The “At Risk” amount is more or less what it means: partners can only deduct losses according to a calculation that measures their risk in the limited partnership. Here’s how it works under ss. 96(2.1) and (2.2):

1. Add the adjusted cost base of the limited partner’s interest at the time of computation;
2. Add the the partner’s share of income of the partnership for the current fiscal period;
3. Subtract all amounts owing by the partner to the limited partnership or to a person with whom the partnership does not deal at arm’s length with; and
4. Subtract any amount or benefit which tends to reduce the investment risk to the limited partner.

If there is an excess in this calculation (i.e. a limited partner’s share of losses is greater than their “at risk” amount), then this amount could be carried forward indefinitely (but not backwards) if certain requirements are met: s. 111(1)(e). Again, it’s best to speak with an accountant and a lawyer to find out more about the tax treatment of limited partnerships.

Disclaimer:
Please note that the information provided herein is not legal advice and is provided for informational and educational purposes only. If you need legal advice with respect to drafting, reviewing, interpreting or resolving disputes concerning partnership and limited partnership agreements, you should seek professional assistance (e.g. make a post on Dynamic Lawyers - http://www.DynamicLawyers.com/). We have Toronto, Ottawa, Hamilton, Mississauga, Brampton, and other Ontario business lawyers registered on the website who can answer your questions or help you with your partnership and limited partnership agreements. I should know – I’m one of them and you can contact me directly.

ABOUT THE AUTHOR: Michael Carabash, B.A., LL.B., M.B.A.
Dynamic Lawyers Ltd. was founded by Michael Carabash, a Toronto business lawyer with Carabash Law. Virtually everyone has a wide range of legal issues they need help with - such as writing a will, fighting a traffic ticket, buying or selling real estate, writing a contract for services, reviewing a lease agreement, having documents notarized or commissioned, dealing with a motor vehicle accident, etc. Michael wanted ordinary people in need of common legal services to be able to conveniently and cost-effectively get answers and quotes from local lawyers. At the same time, he also wanted lawyers to be able to market their services directly and effectively to the public.

Name: Michael Carabash
Email: peter@dynamiclawyers.com