While partnerships have existed for as long as people have been in business, their use in Canada has been relegated largely to certain industries and tax situations. The rules governing partnerships legally and under the Income Tax Act (the Act) generally are not as well defined or understood as those for corporations. However, given the increasing complexity of the corporate tax regime – especially for private corporations – partnerships can be flexible, practical alternatives to structuring many businesses. This is particularly true of limited partnerships.
In a corporate structure, the corporation is viewed as a separate person under the Act. The corporation calculates taxable income, pays corporate tax and distributes profits as dividends to shareholders. A corporation also provides liability protection to its shareholders, though significant shareholders may be called on to offer guarantees of certain corporate liabilities such as bank debt.
A partnership is, in many ways, the mirror opposite of a corporation. A partnership does not calculate taxable income and does not pay income tax. It distributes earnings (or losses) directly to the partners, who include such income or losses in the calculation of their own taxable income (and pay income tax accordingly). Unlike shareholders of a corporation, partners in a general partnership are not offered a shield from liabilities of the partnership. The partners are responsible for the debts and obligations of the partnership as if they were their own. However, a special type of partnership – a limited partnership – may be used to limit the liability of the limited partners while maintaining the flow-through characteristics that make partnerships attractive vehicles for structuring investments.
A limited partnership has two types of partners: limited partners and general partners. All limited partnerships must have at least one general partner. The general partner is responsible for decision-making functions and has unlimited liability for partnership obligations. Limited partners do not take an active role in management and have their liability for partnership obligations limited to the amount of any equity contributed to the partnership. Limited partners who take an active role in managing a partnership may jeopardize their status as limited partners. It is common for the general partner of a partnership to operate through a corporation incorporated solely for the purpose of managing the affairs of the partnership, while the remaining partners make their contributions as limited partners.
One of the key benefits of a partnership is the flexibility offered within a partnership agreement to allocate income on different bases to different partners depending on their contributions. For example, several parties might bring different elements to a business deal and might want to recognize those contributions in different ways. One partner might be responsible for putting the deal together and will take a more active role in seeing it through, while a second partner might bring capital assets and a third partner might contribute funds. The partners may agree to allocate future income in a manner that rewards these contributions in different ways (i.e. by paying a preferential return of profit to the partners contributing hard assets, followed by a different allocation of residual income between the partners, depending on the project's level of success).
While similar results are possible in a well-crafted corporate structure – using a combination of different share classes and loans – interest is taxed on an accrual basis regardless of whether distributions are available. In contrast, with a partnership, no tax is payable by partners until they actually receive an allocation of income from the partnership. Losses may also be streamed to partners, subject to certain restrictions discussed below, whereas losses incurred by a corporation are trapped within the corporation.
With this added flexibility, why are limited partnerships not used more frequently? First, limited partnerships are not as well understood as corporate structures. They can cause practical difficulties when working with less sophisticated lenders or simply in day-to-day administration. They are subject to complicated restrictions under the Act that serve as pitfalls for the unwary. The most common unpleasant surprise at tax time is a failure to understand the basic mechanics behind the at-risk and adjusted cost base (ACB) rules.
A partner's ACB is defined in section 53 of the Act. In simple terms, the ACB of a partnership interest at any time is the cumulative contributions to the partnership by the partner, plus the income allocated to the partner before that time, less the cumulative distributions to the partner, less the losses allocated to the partner before that time. Many other adjustments can affect the ACB calculation, making professional assistance important. Further, ACB should be calculated on an ongoing basis. Should the ACB of a limited partnership interest be negative at the end of the partnership's fiscal period, the negative amount will give rise to a capital gain to the partner. Certain exceptions to this general rule are available for some partners who do not have limited liability protection.
The most misunderstood reference in this area is the timing of the addition to the ACB for income allocated to a partner. The ACB allocation only considers income allocation to a partner "before that time." Thus, income allocations increase the ACB of a partnership interest only on the day following the end of the year. A practical problem arises when income is distributed to partners on an ongoing basis, such that a negative ACB occurs at the end of the year.
For example, consider a limited partner with an ACB of $1 as of January 1, 2017. The partnership, which has a December 31 year-end, earns $10 of net income for tax purposes during the year, allocable to the limited partner. However, the partnership also generates $10 in free cash flow, which is distributed during 2017. As of December 31, 2017, the limited partner has a negative ACB of $9 ($1 opening balance less $10 in cash distributions). The income allocation of the partnership for 2017 does not increase the ACB until, effectively, January 1, 2018. Thus, on December 31, 2017, the limited partner must report the allocation of partnership income of $10 and a capital gain of $9. On January 1, 2018, the ACB is increased by the amount of the capital gain of $9 plus the amount of the income allocation of $10, to $10 in total.
A carry-back mechanism permits a positive adjusted cost base to be carried back to offset a previous year's deemed gain for most partners, but this is not always effective depending on timing, and does not mitigate the time value of the tax payment. Another aspect often overlooked is the fact that a deemed gain from a negative partnership ACB does not generate an addition to the capital dividend account. This can be particularly problematic depending on how a deemed gain is reported on a corporate tax return, given that the Canada Revenue Agency might not have the correct information on file, even if a confirmation of the capital dividend account is obtained.
Another common source of misunderstanding is the calculation of the at-risk amount (ARA). The ARA is meant to limit the allocation of tax losses to limited partners to the extent of their capital at risk in the partnership. The ARA is reduced by amounts due to the partnership from the partner to ensure that it properly reflects the equity at risk and prevents the use of partnership loans to stream losses to the partner in excess of the partner's cash outlay. However, these provisions are broadly worded and can cause other debts within closely held partnership groups to reduce the ARA, often in unexpected ways. Losses are only available to the extent of the ARA. Excess losses are carried forward and usable when a positive ARA exists. The ACB and ARA should be managed proactively to ensure that losses may be used effectively and to avoid unnecessary deemed capital gains.
Some less technical pitfalls encountered by many limited partnerships involve the failure to ensure that the partnership agreement accurately reflects the intention of the partners. Partnership agreements typically cover three key areas in respect of allocations: distributions of cash, allocations of accounting income or losses and allocations of taxable income or losses. Over the life of a partnership agreement, all three should align in most cases, but there may be significant timing differences.
A common pitfall can affect partnerships who fail to model out the allocations under different scenarios to ensure that income and loss allocations are aligned over the life of the project and to optimize the use of losses that may be incurred by the partnership.
There is significant latitude when drafting a partnership agreement to ensure that, for example, losses are streamed to partners who have contributed capital and have positive ARA balances. However, drafters should ensure that the provisions in the agreement place partners in the correct position cumulatively. Drafters should explore models to test the allocation and distribution provisions under a variety of scenarios, such as what occurs when there is positive accounting income but negative taxable income in a given year, or when there are cash distributions with no taxable income allocations. The Act provides that unreasonable allocations of income may be adjusted by the minister. Barring that, any reasonable allocation should be acceptable.
Limited partnerships can provide unique flexibility and, if properly structured, can offer many of the liability protections available to shareholders of corporations. The ability to stream income and losses directly to partners can be beneficial in many circumstances. However, professional advice is required when setting up a limited partnership and – on an ongoing basis – to avoid the many tax pitfalls. Contact your Collins Barrow advisor for help.
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.
