LIFECYCLE OF A PARTNERSHIP FREEZE

These materials were prepared by Penny Leckie, CA, CMA, TEP, Ernst & Young LLP Chartered

Accountants, for a conference held in Calgary, Alberta hosted by Pacific Business & Law

Institute, March 16, 2004

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TABLE OF CONTENTS

INTRODUCTION1

PLANNING AND IMPLEMENTATION

- Objectives of the “freezor”

- Identification of partners

- Subsection 97(2)

- Canadian Partnership

- Eligible property

- Proceeds of disposition

- Adjusted Cost Base of Partnership Unit

- Deemed proceeds of disposition

- Subsection 97(1)

- Stop-loss provisions

- Partnership unit attributes

- Control of the partnership

- Existence of a partnership

- Recognition of the freeze

- Election

OPERATION AND USE OF THE PARTNERSHIP

- Income allocations

- Members vs non-members

- Small business deduction of corporate partners

- Attribution to “freezor”

- Kiddie-Tax

- Capital gains deduction

- Foreign issues

DEATH OF THE “FREEZOR”

- Deemed disposition

- Spousal rollover

- Electing out of spousal rollover

- Valuing units

- Life insurance proceeds

WINDING-UP

- Transfer to corporation

- Taxable transfer to partners

- Tax-deferred transfer to partners

- Partnership becomes proprietorship

PLANNING OPPORTUNITIES

CONCLUSION

BIBLIOGRAPHY

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Objectives

The purpose of this paper is to outline the lifecycle of a partnership freeze. It will describe how a

partnership may be effectively used in an estate freeze, discuss issues and concerns that should

be addressed when using a partnership as the freeze vehicle, consider implications on death of

the freezor, and discuss alternatives for winding up. Some planning opportunities will also be

identified.

PLANNING AND IMPLEMENTATION

Define Objectives of the Freezor

When individuals are planning for an estate freeze, their objectives typically include some or all

of the following:

Minimize tax applicable on death;

Ensure sufficient liquidity will be available to fund the tax liability on death;

Ensure individuals will have access to sufficient cash flow during their lifetime;

Minimize tax on cash flow received during their lifetime;

Transfer wealth to the next generation in an orderly basis;

Provide for the orderly succession of business assets;

Address unique needs and issues of multiple beneficiaries;

A partnership freeze can be structured to achieve the majority of these objectives. In addition,

depending on the individual‟s circumstances, a partnership freeze may yield additional planning

opportunities and benefits.

Identifying Potential Partners of the Freeze

Although alternatives exist, a partnership freeze usually involves the creation of a partnership

between an individual or the individual‟s corporation, and a family trust or another related

individual or corporation. It may be necessary for tax and legal reasons to “alter” the identity of

particular desired partners. For example, if the freezor desires to have non-residents or minor

children participate in the partnership, it may be more advantageous to have these interests held

in a trust or a corporation. Further discussion is provided later.

Basic Concept of a Partnership Freeze

A partnership is formed with the parties that are intended to participate in future growth

subscribing for “common” growth partnership interests, at a nominal amount.

The party that is freezing their value, transfers assets to the partnership. In exchange for the

transfer of assets, these parties usually receive “preferred” partnership interests.

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Subsection 97(2)

Subsection 97(2) of the Income Tax Act2 provides for a tax-deferred rollover of assets to a

partnership. However, certain criteria must be met.

Canadian Partnership

In order to qualify for the rollover, the transfer must be to a partnership that immediately after

that time is a Canadian partnership.

“Canadian partnership” is defined in subsection 102(1) as a partnership all of the members of

which were, at any time, in respect of which the expression is relevant, resident in Canada.

In the scenario where an individual has four adult children, three resident in Canada, and one

resident in another country, if the four children acquire growth interests of a newly created

partnership, and the parent subsequently tries to transfer assets on a tax deferred basis

(“rollover”), the rollover will not qualify under the provisions of 97(2). The non-resident partner

will cause the rollover to fall offside, and the transfer of assets will be fully taxable.

A number of solutions exist to resolve this problem. One solution would be for the Canadian

residents to form the partnership, excluding the non-resident child. The parent could transfer

assets pursuant to subsection 97(2). The test for Canadian partnership in subsection 97(2) is

“immediately after that time”. Once the test is met, and the rollover has been achieved, it

appears that the non-resident could subscribe for growth units of the partnership. This solution

will be subject to valuation issues. Also, if any future rollovers were contemplated, including, as

discussed later, a rollover of assets out of the partnership, complications would exist. It is likely

more desirable to preserve the partnership‟s status as a Canadian partnership.

As pointed out by Douglas S. Ewens, QC in his paper to the 1997 Canadian Tax Conference3,

“status as a Canadian partnership is also important where the partnership will receive dividends,

interest or other types of passive income from Canadian residents. Paragraph 212(13.1)(b)

provides that where a person resident in Canada pays or credits an amount to a partnership (other

than a Canadian partnership within the meaning assigned by section 102) the partnership shall be

deemed, in respect of that payment, to be a non-resident person. Accordingly, the payer of the

interest or dividend to the partnership would be required to withhold tax therefrom. Since this

provision would not deem the non-Canadian partnership to be resident of any particular treaty

country, the rate of Canadian non-resident withholding tax that would be required to be withheld,

would be 25 percent. This would impede the partnership‟s cash flow, and complicate the affairs

of all partners.”

Therefore, having the non-resident acquire a partnership interest after the rollover is not the

optimal solution.

A better solution would be to have a corporation or a trust, resident in Canada hold the

partnership interest for the non-resident.

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In circumstances where one of the partners plans to leave Canada, consideration should be given

to transferring the partnership interest to a corporation resident in Canada, prior to departure.

Eligible Property

The types of assets eligible for rollover under 97(2) are similar to the assets, which may be rolled

over to a corporation in subsection 85(1). Subsection 85(1.1) defines “eligible property” for

purposes of subsection 85(1). The definition includes capital property, Canadian resource

property, foreign resource property, eligible capital property, and inventory (other than real

property). The significant difference between 97(2) and eligible property as defined in 85(1.1) is

that 97(2) does not preclude an inventory of real property from being eligible for rollover.

Therefore, an inventory of real property may be rolled to a partnership but not to a corporation.

In the past, taxpayers have transferred inventory of real property to a partnership, pursuant to

97(2), and then have transferred their partnership interest to a corporation pursuant to 85(1).

Canada Revenue Agency (“CRA”) has indicated that GAAR would apply in these

circumstances.4 Recently, though, in the case of Loyens

5, taxpayers were successful in

implementing this strategy to access losses in a corporation, prior to a sale to a third party. Of

particular note in the Loyens case is the fact that the shareholders of the corporation were

identical to the partners of the partnership, ie it was not an arm‟s length corporation. Also, the

corporation that was used for the transfer was not the ultimate purchaser of the land. The land

was sold out of the corporation, to a third party. The proceeds on the sale, were reported as

regular income, by the corporation, not reported as capital gains, so income was not converted

into capital gains through this series of transactions. Given this particular set of circumstances,

the court determined that the transactions did not result in a misuse or abuse of the Act. It is a

question of fact, unique to each scenario, as to whether or not GAAR could apply if

implementing this strategy.

Joint Election

When assets are transferred to a partnership, under subsection 97(2), a joint election between the

transferor and the partners of the partnership must be completed and filed. To simplify

administration, one partner is typically given authority, and for the purposes of the election, acts

on behalf of all partners.6

Reference sources are readily available,7 to provide guidance regarding actual filing of the

election. As such, these details are not discussed further.

Proceeds of Disposition

The amounts a transferor may elect pursuant to 97(2) are similar to those under 85(1). When

determining an elected amount, the transferor must give particular attention to the cost of the

assets transferred, their fair market value, and consideration received in exchange for the

transfer, including assumption of debt.

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In circumstances where debt associated with an asset exceeds the adjusted cost base of the asset,

for example, if real estate with accrued gains has been leveraged, then additional planning may

be required to avoid gains being realized on transfer into a partnership.

The amount elected by the transferor will become the proceeds of disposition on the assets

transferred, and the adjusted cost base of the assets received in exchange, usually an interest in

the partnership.

Adjusted Cost Base of Partnership Unit

The initial adjusted cost base of a taxpayer‟s partnership unit will be equal to the partner‟s actual

cost for the unit, or the amount elected pursuant to subsection 97(2).

The calculation of a taxpayer‟s adjusted cost base of a partnership unit is a cumulative

calculation, which takes into consideration adjustments as described in paragraphs 53(1)(e) and

53(2)(c ). The exact timing of the calculation is often relevant, as the adjusted cost base will

change, at various points in time.

Although this list is not exhaustive, the most relevant increases to the adjusted cost base are for

the partner‟s share of income of the partnership, added after the end of each fiscal period of the

partnership, and contributions of capital from the partner to the partnership, added at the time the

contribution is made. The most relevant deductions from a partner‟s adjusted base are a

reduction for the partner‟s share of partnership losses, after the end of the partnership‟s fiscal

period, as well as a reduction for withdrawals of capital by the partner from the partnership, at

the time the funds are withdrawn.

Deemed Proceeds of Disposition

As discussed above, when an individual withdraws funds from a partnership, the adjusted cost

base of his partnership interest, is reduced, accordingly. Where, at the end of a fiscal period of a

partnership, a member of the partnership is a limited partner or a specified member of a

partnership, subsection 40(3.1) will cause a deemed disposition if the adjusted cost base of his

partnership interest is negative.

Where a partner is a general partner, active in the business activities of the partnership, no

deemed disposition will occur.

A number of cases exist8, where parties have tried to thinly disguise a sale of assets, and take

advantage of the above provisions. Although the fact pattern in each of the cases differs, the

majority of these cases have failed, and the withdrawal is deemed to be proceeds of disposition.

The most predominant of these cases is Stursberg. In this particular case, it was a question as to

whether or not amounts received by the taxpayer, and effectively replaced by another partner,

should be considered a distribution, or a disposition. The court concluded that because the

partnership had no profits from which a distribution could be made, because there was no

effective alteration or reduction in the overall capital of the partnership, and because the

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taxpayer‟s ability to receive funds from the partnership, in this particular circumstance, was

conditional upon the partnership receiving funds from another partner, the funds received by the

taxpayer was not a distribution of capital, but rather, was a disposition of a portion of his

partnership interest.

Care should be taken, when planning, to ensure that the intended tax results to the transferor

occur. Proceeds of disposition to be reported by the transferor will be driven by the amount

elected pursuant to subsection 97(2), combined with actual consideration received, both

immediate and deemed.

Subsection 97(1)

If assets are transferred to a partnership, and the rollover provisions of subsection 97(2) are not

met, subsection 97(1) provides that where a partnership has acquired property from a taxpayer

who was, immediately after that time, a member of the partnership, the partnership shall be

deemed to have acquired the property at an amount equal to its fair market value at that time and

the taxpayer shall be deemed to have disposed of the property for proceeds equal to that fair

market value.

This subsection may create onerous tax results, if the actual intention is to achieve a deferral

under 97(2). However, it may provide a planning opportunity in circumstances where a deferral

is not required, for example if losses are carried forward, it may be desirous to have a transfer

take place at fair market value.

Stop-loss Provisions

When transferring assets, consideration should be given to the “stop-loss” provisions in

subsections 40(3.3) and 13(21.2). These provisions will apply to prevent a corporation, trust or

partnership from realizing a loss on transfers to affiliated persons.

Subsection 251.1(1) provides that a partnership may be affiliated with the following:

a corporation controlled by a particular group of persons each member of which is

affiliated with at least one member of a majority-interest group of partners of the

partnership, and each member of that majority-interest group is affiliated with at least one

member of the particular group;

a majority interest partner of the partnership;

another partnership, if the same person is a majority-interest partner of both partnerships,

a majority-interest partner of one partnership is affiliated with each member of a

majority-interest group of partners of the other partnership, or each member of a

majority-interest group of partners of each partnership is affiliated with at least one

member of a majority-interest group of partners of the other partnership.

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A majority interest partner is defined in subsection 248(1) as a taxpayer whose share of the

income, when combined with any affiliated person, exceeds one-half of the total partnership

income, or the portion of the partnership assets receivable by that group on winding up exceeds

one-half of the total assets of the partnership.

Where the transferor is an individual, these “stop-loss” provisions are not applicable.

In the event that a transfer is from an individual to an affiliated person, care should be taken to

ensure that the transfer does not fall under the “superficial loss” provisions in Section 54.

Attributes of Partnership Interests

To ensure sufficient value is attached to preferred partnership interests, when using a partnership

as the vehicle for a freeze, consideration should be given to the guidelines for preferred shares of

corporations.

CRA9 has expressed the view that the following attributes are necessary to establish the value of

preferred shares issued to effect an estate freeze:

(a) the preferred shares must be redeemable, retractable and have a reasonable dividend rate,

(b) the preferred shares should be voting (at least in matters affecting the shares),

(c) the preferred shares must have preference on any distribution of the assets of the

corporation on any liquidation, dissolution or winding-up,

(d) there should be no restriction on the transferability of the preferred shares (other than as

required by corporate law), and

(e) the issuing corporation must undertake that no dividends will be paid on the other classes

of shares which would result in the corporation having insufficient assets to redeem the

preferred shares at their redemption amount.

In question 45 at the 1981 Revenue Canada Round Table10

, CRA stated that the absence of a

preferred dividend rate would not, in and by itself, be viewed as reducing the value of the

preferred shares.

CRA is of the view that its criteria may be met by preferred shares having terms which permit

dividends to be paid on the common shares without payment of dividends on the preferred

shares, provided the other requirements listed above are met. In particular, the payment of

dividends on the common shares must not result in the corporation having insufficient net assets

to redeem the preferred shares at their redemption amount.

A partnership unit structure, as used in a freeze environment usually has at least one class of

fixed value units, which are issued to the freezor in consideration for the assets transferred to the

partnership. These preferred units typically provide that the owner is entitled to receive the full

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amount of value in the event that the partnership ceases to exist in preference to any other class

of units. These units should also contain a price adjustment clause in the event that the

subsection 97(2) transfer is reviewed by the CRA. If the freezor desires, these units may provide

for a return of capital, at a rate determined at the time of issuance. It may be desirable to provide

that holders of the growth units may not draw on the capital allocated to their interests, if such

draw would result in the partnership having insufficient funds to return the capital of the

preferred unitholders. These units typically provide that the owner will be entitled to all of the

realized gain on any assets transferred to the partnership, up to its fair market value on the date

of transfer. Thereafter, capital growth is allocated to the growth units. Future income on

reinvested funds should be shared pro-rata.

The growth unitholders will receive any value in excess of that accruing to the preferred

unitholders.

The terms of a typical partnership agreement used in an estate freeze were described in Cy Fien‟s

1994 Conference Report paper11

. “Typically, the partnership agreement would give the preferred

partners a retraction privilege in respect of their special partnership interest, as follows:

The holder of the preferred partnership interests shall be entitled to require the partnership

to redeem the preferred partnership interests at any time upon 20 days‟ written notice to all

other partners. Upon the receipt of such request, the partnership shall redeem the preferred

partnership interests by paying to the holder thereof the sum determined in paragraph X

hereof [which sum will be defined as the purchase price of the assets net of any liabilities

assumed by the partnership], in this agreement referred to as the “retraction price”. From

and after payment of the retraction price to the holder of the preferred partnership interests,

the holder thereof shall not be entitled to any further rights or privileges in respect of the

partnership.”

Each situation will have its unique structuring and partnership agreement requirements, which

will be driven by personal and business issues. While trying to accommodate these factors, it is

important to ensure that sufficient value is received by the freezor, such that the freeze does not

trigger deemed benefit or “anti-gifting” provisions.

Limited or Unlimited Liability

Partners should have a clear understanding of liability exposure, prior to committing to a

structure. As a general rule, partners have unlimited liability with respect to the activities of the

partnership. Most families do not want this level of exposure. To resolve this concern,

partnership freezes are usually structured as a limited partnership, with a corporation as a general

partner. Alternatively, if a limited partnership is not desired, partnership interests may be held

through corporations. The optimal structure will depend on the intended business activities of the

partnership, its potential for liability exposure, personal concerns of the family members and

type of assets subject to the freeze.

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“Control”

Most individuals are prepared to give up future growth of their assets, but are not prepared to

give up control over their assets.

In a corporate environment, this issue is usually resolved by issuing a special class of voting non-

participating shares.

In a partnership environment, this issue may be resolved by having a corporation act as general

partner, with authority to act on behalf of the partnership. The individual that wants to retain

control of the assets will hold voting control of the general partner.

Alternatively, the partnership agreement could provide how assets are to be managed, and

decisions made. The terms of the preferred partnership units could provide for control over the

assets, and decision making powers.

Other Estate Freeze Concerns

Any time a family is involved in the process of planning for an estate freeze, a number of issues

need to be addressed. These issues may include determining which child will participate in the

business, providing for children not active in the business, etc. A complete list of these potential

issues is beyond the scope of this paper. In planning to implement the estate freeze with a

partnership, these issues will still need to be resolved, typically through the design of the

structure of the overall estate.

Existence of a Partnership

A concern, which is unique to partnership freezes, is whether or not a partnership actually exists,

and whether or not CRA will actually recognize the freeze.

In order to qualify for the rollover provisions under subsection 97(2), the transfer must actually

be to a partnership, of which the taxpayer is a member. If it was determined, that a partnership

did not exist, the partners would fall outside of subsection 97(2), and the transfer of assets to the

partnership would be fully taxable.

Description of a Partnership

Through proper care and planning, the issue of whether or not a partnership actually exists, is

usually manageable.

The Income Tax Act12

does not define a partnership. IT-9013

provides that generally speaking, a

partnership is the relationship that subsists between persons carrying on business in common

with a view to profit.

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Most provinces across Canada have a similar definition of partnership. The Partnership Act14

of

Alberta defines a partnership to mean the relationship that subsists between persons carrying on a

business in common with a view to profit.

For estate planning purposes, it is important to note the following:

A written agreement is not required, rather, the existence of a relationship, itself, may be

sufficient to create a partnership.

The persons involved must be carrying on a business in common with a view to profit. If

a business in common, or a view to profit, does not exist, the partnership may not exist.

The definition of business in the Alberta Partnership Act15

is very broad. It is defined to include

every trade, occupation and profession.

Subsection 248(1) of the Income Tax Act16

defines business to include a profession, calling,

trade, manufacture or undertaking of any kind whatever and except for certain provisions, an

adventure or concern in the nature of trade but does not include an office or employment.

Presumably, if an individual has sufficient net worth, that an estate freeze is being considered,

and given these broad definitions, it seems logical that some form of business is being carried on,

and that a business exists. However, in cases where the business activity is not self-evident, care

should be taken when drafting documents, when structuring the partnership, and when

implementing the transfer of assets, to make reference to business activities.

In his 1994 paper,17

Cy Fien expresses concern that unless the preferred partnership interests are

designed to have some rights to profit, even if relatively nominal, exposure exists that the

preferred partnership interests would not be considered partnership interests, and the partners

would be denied the rollover under 97(2).

To minimize this exposure, when drafting partnership agreements, consideration should be given

to providing all partners, with some right to profit.

The predominant case for assessing whether or not a partnership actually exists, is Continental

Bank Leasing.18

In this case, a rollover, under subsection 97(2) was challenged, by the Minister,

on the premise, that no partnership really existed. The Minister contended that the only purpose

for the partnership agreement was to take advantage of tax planning provisions, and that there

was no true substance to the existence of the partnership. Ultimately, the Courts concluded that

the parties intended to conduct business, and that a business existed. Peter McQuillan‟s

comment on this case19

was “tax motivation does not invalidate a partnership where the essential

element of a partnership is present: the partners must be carrying on a business in common with

a view to profit.”

When planning for a partnership freeze, it is imperative that a business purpose for the

partnership exist, and that the parties carry through with the business activities. If this cannot be

demonstrated, the parties may be exposed to reassessment.

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Canada Revenue Agency Position

A less manageable risk with respect to partnership freezes is whether or not CRA will accept

these structures as an estate freeze vehicle.

To date, CRA has neither indicated that they will accept these structures as an estate freeze

vehicle, nor have they indicated that they are not willing to accept these structures as an estate

freeze vehicle.

In comments provided at the 1992 Conference Round Table20

, CRA did not comment on the

viability of a partnership as a freeze vehicle, rather, they indicated that if the circumstances

warranted, the provisions of 103(1) or 103(1.1) could apply.

The uncertainty surrounding the application of 103(1) and 103(1.1) is a major roadblock in

partnership freezes. This is the main reason why practitioners prefer to structure freezes with a

corporation, rather than a partnership, even though greater tax integration would be achieved via

a partnership structure.

OPERATION AND USE OF THE PARTNERSHIP STRUCTURE

Income Splitting Issues

Subsection 103(1) provides “Where the members of a partnership have agreed to share, in a

specified portion, 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.”

Subsection 103(1.1) provides “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.”

When asked “Would Revenue Canada apply the provisions of subsection 103(1) or subsection

103(1.1) if a partnership were used as a vehicle for estate freezing?”21

, CRA replied, “Whether or

not a partnership is used for estate freezing purposes, the Department is of the view that the

allocation of income within a partnership should recognize the capital contributions of the

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partners, as well as the non-monetary contributions of each partner. Otherwise subsections

103(1) or 103(1.1) may apply. In any case, the application of subsection 103(1) and 103(1.1) can

only be determined on the basis of the specific facts, so it is not possible to say that these

provisions would or would not have any application if a partnership were used as a vehicle for an

estate freeze.”

As Peter McQuillan and James P. Thomas describe in their book22

, these two subsections grant

the Minister the discretion to challenge allocations if they are unreasonable.

However, the two provisions grant discretion to the Minister differently.

In order for CRA to apply subsection 103(1), the Minister must be able to prove that the

principal reason for the partners‟ allocation agreement was the reduction or postponement of tax,

payable.

When related parties are involved, CRA may reallocate income, pursuant to subsection 103(1.1),

in any circumstances that the income allocation is not considered reasonable, regardless of

whether or not the principal reason for the allocation was to reduce a partner‟s taxable income.

When questioned on the application of these provisions, CRA is consistent in indicating that

whether or not it will apply the provisions of 103(1) will be contingent upon the facts applicable

in each unique set of circumstances.

Consider the example of a father that wishes to freeze the value of his business, and transfer

future growth of the business to his two daughters. One daughter participates in the business, but

the second daughter does not. The father wishes to provide for his daughters equally. The

business has a fair market value of $1 million and generates annual income of $250,000.

The partnership agreement will be structured such that the father receives a preferred partnership

interest valued at $1 million, in exchange for the business. The father will be entitled to a 5%

return on his capital, each year. The daughters will each acquire 50% of the common interests of

the partnership for a nominal amount, and will share equally in the profits.

If this structure was implemented, it is highly likely that CRA would reassess the income

allocations. An argument might be made that the principal reason for the income allocations was

not a reduction of taxable income of one of the partners, and the provisions of 103(1) might be

avoided. However, because the partners do not deal at arm‟s length, and given their relative

contributions of capital and involvement in the business, CRA would likely be successful in

arguing that the income allocations were not reasonable in the circumstances.

Possible solutions to this dilemma might be to have the daughters‟ interest held in a family trust,

or have the active daughter as a partner, and provide for the other daughter during the estate

planning process, with other assets.

Assume that only the father and the active daughter participate in the partnership, with the father

holding the preferred partnership interest, the daughter holding the common interest, and

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receiving all of the annual profits, after the 5% return of capital to the father. Would CRA

consider the income allocations unreasonable, and reallocate pursuant to subsection 103(1.1)?

CRA provides guidance on this in Interpretation Bulletin 231-R223

. Essentially, it will depend

on the level of involvement in the business, by both partners, the relative value placed on that

involvement, and the relative value placed on their talents and skills. As indicated above, it will

depend upon the circumstances.

Jurisprudence under both of these provisions is limited, and the majority of cases pertain to

allocations of income between spouses, based on relative time spent in a business, and relative

level of expertise. As Douglas S. Ewens, QC24

commented, “The cases that have focused to date

on subsection 103(1.1) tend to compare the facts before the court with how arm‟s length parties

would have behaved in similar circumstances.”

One case, of particular note, and which addresses the issue of capital contributed to the

partnership, is Fraser25

. In this case, the taxpayers were successful in arguing for the income

allocation from the partnership. One sister held a larger interest in the partnership, but because

the other sister had contributed a larger amount of capital, and business reasons warranted that

capital contribution, the Judge stated, “In the Court‟s view, in 1991 and 1992, the amount of

taxable dividend income allocated to each Appellant by the partners is reasonable in view of the

investment of capital by Mrs. McDougall, the withdrawal by Mrs. Fraser, and of the income

available to the partnership. The amount of income allocated by the Minister for each of these

years is unreasonable having regard to the commercial realities of Mrs. McDougall‟s investment,

the security for that investment, and the normal requirements of an investor of capital in a small

enterprise such as that carried on by the partnership.”

The Judge‟s comments affirm the “arm‟s length” approach.

CRA has indicated26

“If a capital contribution is made by one partner out of funds transferred by

gift or loan directly or indirectly from another partner with whom the transferee does not deal at

arm‟s length and the transfer was made to enable the transferee to make that contribution, for the

purposes of determining the respective capital contributions of the partners for the purposes of

subsection 103(1.1) the contribution is viewed as that of the transferor rather than the transferee.

However, this view is not taken when the funds are transferred by means of a loan for a

reasonable term that bears interest at a commercial rate.”

Douglas S Ewens, QC appears to disagree with this approach.27

“It is the writer‟s opinion that

Revenue Canada‟s view on this point goes far beyond what subsection 103(1.1) actually

envisages. In the writer‟s view, generally the source of a partner‟s capital is not relevant.”

“Nowhere in subsection 103(1.1) is there any mention of the source of a capital contribution

made by a partner to the partnership. Although subsection 103(1.1) does leave open the ability

to consider „such other factors as may be relevant‟, it is submitted that the only factors that can

be relevant to the determination of a provision in a partnership agreement relating to the

allocation of income, loss or other tax-related amounts are matters arising out of the relationship

among the partners, including the partnership agreement into which they have entered.”

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It is apparent that subsections 103(1) and 103(1.1) provide CRA with a powerful tool to

challenge income allocations between partners, particularly partners that do not deal at arm‟s

length.

Further the lack of jurisprudence and administrative interpretations, using actual scenarios,

leaves advisors with limited guidance for applying these provisions in practice.

To mitigate exposure to reallocation of income, under these provisions, practitioners should use

caution when drafting an agreement for a partnership freeze. The “arm‟s length” approach

should be borne in mind when providing for income allocations under the agreement. Rationale

for such allocations should be documented carefully.

Members of a Partnership

The wording in subsections 103(1) and 103(1.1) is interesting in that it refers only to the

members of the partnership, and only provides for reallocation among members of the

partnership. It does not include the ability to reallocate to taxpayers related to members of a

partnership.

The provisions do not address circumstances where an individual might be a member of a

partnership, and a related party, for example, a corporation, that is not a member of the

partnership, has income distributed to it, from the partnership.

Continuing with the example above, assume that the business operated by the partnership is the

management of a number of rental properties. Consistent with above, assume that the father

transfers the rental properties to the partnership, on a tax-deferred basis, and receives preferred

partnership interests in exchange for the properties. The preferred partnership interests provide

for a 5% return each year, on the capital contributed. Again, assume that both daughters acquire

the growth units of the partnership, for a nominal amount. However, assume that the daughter

that is active in the business forms a corporation to provide management services to the

partnership. The corporation enters into a management services contract with the partnership,

for an annual fee of $200,000 which as noted above, is essentially all of the income of the

partnership, other than the amount paid as a return on capital.

Assuming the income is active business income, and assuming the corporation is not considered

to be a personal services business, the income would likely be eligible for the small business

deduction in the corporation. The income would effectively be taxed at a lower rate, in the

corporation, as compared to being taxed immediately in the active daughter‟s personal income.

The corporation is not a member of the partnership, therefore, it is the writer‟s opinion that CRA

would have difficulty in applying the provisions of 103(1) or 103(1.1) to reallocate the income.

The provisions of 103(1) and 103(1.1) provide for reallocation among members of the

partnership, but do not include any related parties of said members.

In taking this approach, consideration should be given to the definition of partnership. As

previously noted, the definition of partnership is very broad. It does not require that partners

16

enter into a written agreement, rather it is based on a relationship. CRA may take the position

that even though the corporation providing the management services is not written into the

partnership agreement, and even though the corporation does not hold partnership interests, the

corporation is participating in a relationship, carrying on a business in common, with a view to

profit, and as such, is actually a member of the partnership. If CRA was successful in making

this case, it could presumably apply the provisions of 103(1.1) if it felt the income allocations

were unreasonable in the circumstances.

Further, even though the corporation may not be considered a member of the partnership, CRA

may take the position that the members of the partnership were the ones who agreed to enter into

the management services contract with the corporation, and as such, it was the members of the

partnership that agreed to the income allocation. CRA might be successful in using this

argument to apply the provisions of 103(1) or 103(1.1) and reallocating the income, which was

originally paid to the corporation, amongst the members of the partnership.

To date, there is no jurisprudence with respect to the scenario where income is distributed to

non-members of a partnership. It is difficult to assess what approaches CRA may take.

It is the author‟s opinion, that in situations similar to the previous example, it is more likely that

CRA would rely on Section 67, which limits the deductibility of expenses unless they are

reasonable in the circumstances. It seems that it would be easier for CRA to make this argument,

than to try and demonstrate that the corporation is actually a partner, or to try and demonstrate

that the partners agreed on the allocation, and then still have to demonstrate, in both cases, that

the allocation to the corporation was unreasonable. That said, even an argument under Section

67 is based on facts and circumstances, and may be difficult to prove where the daughter is

working long hours, and charging fees through the corporation.

Small Business Deduction

It is not the intention of this paper to provide an expanded explanation or analysis of the small

business deduction. However, because of the definition of “specified partnership income”,

contained in subsection 125(7), the after-tax results of a partnership freeze may differ from what

an individual perceives to be the “equitable” results intended when they are contemplating a

partnership freeze.

When structuring a partnership freeze, if certain partners desire to hold their interests in a

corporate entity, consideration should be given to these provisions, and what impact such

ownership may have on the corporation‟s overall tax position.

Attribution

Although, as noted above, Mr. Ewens does not think CRA should use “source of capital” as their

basis for reallocations of income under 103(1.1), whenever individuals are undertaking estate

planning, consideration should be given to attribution and gifting provisions.

17

If an individual gifted an amount to his spouse, his minor children, or a trust in which his spouse

or minor children and nieces or nephews are beneficiaries, and those funds were used to acquire

an interest in a partnership, subsections 74.1(1), 74.1(2) and 74.3(1) would apply to attribute any

income or loss earned on that partnership interest, back to the individual that made the gift.

Further, on the disposition of the partnership interest, by the spouse, subsection 74.2(1) will

attribute any capital gain back to the individual that made the gift.

If transfers by individuals to their spouses or their minor children are for fair market

consideration, subsection 74.5(1) will prevent the attribution provisions in 74.1(1), 74.1(2) and

74.2(1) from applying.

Subsection 56(4.1) applies where an individual has lent funds to a related party. If it can

reasonably be considered that one of the main reasons for making the loan was to reduce or

avoid tax, then 56(4.1) may attribute income to the lender, unless the exception under 56(4.2) for

loans with prescribed rates of interest and payment terms, is met.

Some may question whether or not income from a partnership would be income from property.

To be certain, in a fiscal period where the person is a specified member of the partnership,

subsection 96(1.8) deems any income received from the partnership to be income from property

for the purposes of subsections 56(4.1) and sections 74.1 and 74.3

Therefore, planning should provide for fair market consideration, and if indebtedness is received

as part of the fair market consideration, interest at prescribed rates or greater should be charged

on the debt. Further, the terms of the indebtedness should provide that interest on the debt shall

be paid no later than 30 days after the end of a particular year.

Kiddie Tax

The provisions of section 120.4 will effectively tax minor children at the top marginal tax

bracket, on various amounts required to be included in their income. Using a partnership

structure in an estate freeze may provide a planning opportunity with respect to these provisions.

For example, assume an individual transfers his investment portfolio of public company shares,

to a private company. Assume the shares of the private company are held by a family trust, of

which his minor children are the beneficiaries. If dividends are paid from the private company to

the family trust, and then allocated to the children, those dividends will be subject to the

provisions of section 120.4. This is caused because the income included in the child‟s income

may reasonably be considered to be derived from the provision of property in support of a

business carried on by a corporation of which a person who is related to the individual is a

specified shareholder.

However, if the individual transferred his investment portfolio to a partnership, and the family

trust was a partner, investment income would “flow through” the partnership to the family trust.

Provided that the child‟s parent or other related individual is not a specified shareholder of the

corporation paying the income to the partnership, the “kiddie tax” provisions should not apply to

income paid from the partnership to the trust, and allocated to the children from the trust.

18

Capital Gains Deduction

The definition of a “qualified small business corporation share” in subsection 110.6(1) provides

for ownership by a partnership, provided that the partnership is related to the individual claiming

the deduction.

Paragraph 110.6(14)(d) provides that for the purposes of the definition of “qualified small

business corporation share” a partnership, shall be deemed to be related to a person for any

period throughout which the person was a member of the partnership.

An effective method for multiplying access to the capital gains deduction is to hold the shares of

a small business corporation through a partnership. This structure may also simplify the sale to a

third party. A partnership structure permits a direct sale of “opco” shares, rather than having to

divest shares of a holding company, when shares of “opco” are held in a “holdco”. A “holdco”

purchase is typically less palatable to third parties, as compared to a direct “opco” purchase.

A partnership may not claim the capital gains deduction, but the gain on the sale of shares of a

qualified small business corporation retains its identity when flowed out to partners. The

partners may claim an offsetting capital gains deduction, based on their individual circumstances.

Similarly, where direct ownership is not desired, the partnership interest may be held in a

discretionary trust. The capital gains will flow from the partnership, and the trustees may

allocate such gains to beneficiaries, using their discretion. Once again, provided that the trustees

designate in the trust‟s return, the capital gains eligible for the capital gains deduction will retain

its identity when it is allocated from the trust, and the beneficiaries may claim an offsetting

capital gains deduction, based on their individual circumstances.

Foreign Issues

A full discussion of all foreign issues, which may arise during operation of a partnership is

beyond the scope of this paper. The following discussion merely highlights some points, which

practitioners should bear in mind:

Non-resident partners of partnerships carrying on business in Canada, are deemed to be

carrying on business in Canada, pursuant to subsection 96(1.6), and as such, will be

obliged to file Canadian income tax returns.

Where a partnership of which there are one or more non-resident members makes a

taxable capital gain on the disposition by it of taxable Canadian property, the gain retains

its identity in the hands of the individual partners by virtue of paragraph 96(1)(f) and

each non-resident partner is required to include in his taxable income earned in Canada

his respective share of the taxable capital gain pursuant to subparagraph 115(1)(a)(iii).28

CRA has indicated29

that for purposes of section 116, the assumptions in subsection 96(1)

are not applicable, such that on the disposition of partnership property, each member is

19

considered to have disposed of his share of that property, and each non-resident partner is

a non-resident person referred to in section 116. Further, the provisions of section 116

will apply to circumstances where a non-resident partner disposes of a partnership

interest that is considered taxable Canadian property. For partnership dispositions, it is

the policy of CRA to accept one Notice of Disposition filed on behalf of all partners.30

As discussed above, non-resident partners will cause a partnership to fall outside the

definition of “Canadian Partnership”. This may prevent partners from accessing tax

deferred transfer provisions on assets being both contributed to and received from

partnerships. It will also cause withholding tax implications on the receipt of passive

income from Canadian sources.

As noted by Peter McQuillan and James Thomas31

“There is no requirement that a

„Canadian partnership‟ carry on any part or all of its business in Canada or be organized

under Canadian laws. If a partnership was comprised exclusively of Canadian residents

who were partners in a U.S. enterprise, that U.S. enterprise would be a „Canadian

partnership‟ for rollover purposes.”

In most circumstances, particularly the rollover provisions, the test for “Canadian

partnership” is at a particular time. Where a partnership has one non-resident partner,

and the other partners wish to access particular rollover provisions, it may be to the other

partners‟ benefit to acquire the non-resident partners‟ interest, prior to proceeding with

the rollover transactions.

Partnerships have been used in structures to minimize exposure to U.S. estate tax. Recent

legal cases in the U.S. have caused practitioners to review these structures. The use of

family limited partnerships, has increased dramatically in the U.S, primarily because of

the significant valuation discounts that result. As such, the Internal Revenue Service has

put these structures under scrutiny, and has challenged these structures in a number of

areas. The strongest and most far-reaching argument appears to be that the transferor

retained possession and enjoyment of the property, and as such, the property should be

included in the transferor‟s estate. The IRS attempts to “look-through” the partnership.

To minimize exposure to this attack, care should be taken to ensure that personal and

partnership funds are not commingled, that distributions to partners are proportionate,

and that the partnership does not appear to be a testamentary arrangement. The position

of the IRS, with respect to these structures, is constantly evolving, and should be

reviewed prior to implementation of these structures.

Annual Compliance

CRA provides that32

“a partnership that carries on a business in Canada or a Canadian

partnership with Canadian or foreign operations or investments, has to file a Partnership

Information Return for each fiscal period of the partnership if it has six or more members at any

time during the fiscal period; is a tiered partnership; or invested in flow-through shares of a

principal-business corporation that incurred Canadian resource expenses and renounced those

expenses to the partnership.”

20

Where a partnership is not subject to the above filing requirements, financial information should

be compiled at the partnership level and provided to partners for reporting on their respective

income tax returns.

DEATH OF A PARTNER

The numerous and potential implications of this event are described in detail in other sources.33

The intent of the author is to highlight the implications of this event, in the circumstances where

a partnership has been used to effect an estate freeze. The author assumes that in structuring the

freeze, it was intended that the estate would receive the freezor‟s partnership interest on death,

and that it was the freezor‟s intention that the partnership would continue.

Deemed Disposition

On the individual‟s death, assuming that the partnership interest is capital property of the

individual, a deemed disposition of the partnership interest, at fair market value, will occur,

pursuant to subsection 70(5).

Spousal Rollover

Subsection 70(6) provides that where property is transferred to the taxpayer‟s spouse, the

provisions of 70(5) are not applicable, and the deemed disposition will be at the taxpayer‟s

adjusted cost base. Further relieving provisions are available in 70(6)(d.1). This paragraph

applies where a partnership interest is transferred to a spouse. It provides that no disposition has

occurred on a taxpayer‟s death, and places the recipient spouse in the deceased‟s position of

ownership. This provision prevents a taxpayer‟s negative adjusted cost base from being realized

as a result of his death.

In order to access the relieving provisions under subsection 70(6), it must be demonstrated that

ownership of the assets “vested indefeasibly” with the spouse within 36 months of the taxpayer‟s

death. Care must be taken when drafting partnership agreements and individual partners‟ wills

to ensure that clauses within those documents do not preclude the spouse from “vesting

indefeasibly” in the ownership of the assets, if that is the freezor‟s intention.

Electing out of Spousal Rollover

The legal representatives of the taxpayer‟s estate may elect, pursuant to subsection 70(6.2), to

not have the provisions of subsection 70(6) apply, in which case, the provisions of 70(5) would

apply, and the assets would transfer to the spouse at their fair market value.

“Stub” Period Income

Depending on the circumstances, it may be possible for the legal representatives of a partner to

file a separate return, in the year of death, to report “stub” period income from the partnership.34

21

Consideration should be given as to whether or not any planning opportunities would exist by

electing that the provisions of subsection 150(4) apply.

Adjusted Cost Base to Estate

The estate will receive the partnership interest, with an adjusted cost base equal to the amounts

reported on the deceased‟s terminal return.

Valuation

In determining the fair market value of the partnership interest, at the time of the individual‟s

death, if fixed value units were used in the freeze, then the value will be determined by the fixed

value of each unit, multiplied by the number of units still held by the individual.

If fixed value units were not used, then the value will be determined by the value of the

underlying assets.

Where the partnership holds a life insurance policy on the individual, subsection 70(5.3)

provides that the fair market value of any property deemed to have been disposed of as a

consequence of an individual‟s death shall be determined as though the fair market value of any

life insurance policy under which the particular individual was a person whose life was insured,

were the cash surrender value of the policy immediately before the particular individual died.

This provision was amended in 2001. The explanatory notes to the amendment indicate that one

of the purposes for the amendment was to clarify that it applied in determining the value of any

property, for example, an interest in a partnership, and was not just applicable to shares. Prior to

this amendment, it was only used as a point of reference for valuing partnership interests.

Life Insurance Proceeds

If a corporation holds a partnership interest in a partnership that has received life insurance

proceeds, the corporation may add the net proceeds of the life insurance to its capital dividend

account, at the time the partnership receives the proceeds, as if the corporation has received the

amount allocated to it, at that time.35

The net proceeds received on a life insurance policy will be added to the adjusted cost base of the

surviving partners‟ interests, immediately after the taxpayer‟s death.

Capital Loss Carry Back

Where a partnership interest, that is capital property, is disposed of, by a taxpayer‟s estate, within

a year of the individual‟s death, and a loss is realized on the disposition, the legal representatives

may elect to carry the loss back to the deceased‟s terminal return.

Planning with respect to a deceased taxpayer‟s terminal return is often driven by the estate‟s

intentions, how assets will be distributed amongst beneficiaries, and whether or not assets will be

liquidated. Alternatives for winding up a partnership are discussed below.

22

WINDING UP A PARTNERSHIP

Timing of Wind-Up

A partnership may be wound up, at any time. The timing of the wind-up will be driven by

business purposes, as well as personal considerations of the partners. For purposes of

demonstrating the potential lifecycle of a partnership freeze, this paper discusses winding up,

after the freezor‟s death. However, should conditions require, the partnership may be wound up

prior to the freezor‟s death.

The main differences that will occur between a windup before death and a windup after death are

as follows:

The adjusted cost base of the partnership units will reflect amounts reported as a result of

a deemed disposition on the deceased taxpayer‟s terminal return.

The partnership may have increased liquidity if life insurance proceeds were received on

an individual‟s death.

The adjusted cost base of the partnership units will reflect any life insurance proceeds

received.

The value of the partnership units may have changed on or after death, to reflect business

issues, such as personal goodwill, or life insurance proceeds received.

These differences will affect the after-tax results to the partners on wind-up, but the tax

principles that will apply are identical, regardless of whether a wind-up is implemented before or

after a freezor‟s death.

The method for winding-up a partnership will be driven by the intentions of the partners, ie

whether or not its intended for the business to continue, and whether or not the partners intend to

remain involved in the business.

Transfer to a Corporation

The provisions of subsection 85(2) permit assets of a partnership to be transferred to a

corporation, on a rollover basis, provided that all partners elect. The requirements of 85(2) are

similar to 85(1). However, capital property that is real property may not be transferred unless the

partnership is a Canadian partnership.

Consistent with 85(1), an inventory of real property, may not be transferred. As discussed

previously an alternative solution to resolve this issue, may be to have the partners transfer their

partnership interests to the corporation, under 85(1).

In 85(2), consistent with 85(1), consideration must include shares of the transferee corporation

and the transferee must be a taxable Canadian corporation. It is beyond the scope of this paper to

discuss all matters pertaining to an election under 85(2), but reference sources are readily

available.36

23

Once a transfer pursuant to 85(2) has been completed, the partnership will still exist. However,

it will hold shares of the corporation and money received from the corporation, as its assets,

rather than the original business assets.

The provisions of subsection 85(3) provide the rules that apply where assets of a partnership are

transferred to a corporation, pursuant to 85(2). The partnership will be governed by these rules

if, within 60 days the partnership is wound up, and all that exists in the partnership, prior to

wind-up is money or property received from the corporation. If these conditions are not met, the

dissolution will be a taxable event under 98(2).

The intention of 85(2) and 85(3) is to provide a tax-deferral on the effective conversion from a

partnership to a corporation37

. However, depending on the circumstances, the conversion is not

always tax-free. Tax implications may occur where partners‟ adjusted cost base of their

partnership units is proportionately different from their proportionate ownership of the fair

market value of the assets. Depending on the circumstances, this problem may be resolved by

distributing cash disproportionately to shares, on the dissolution.

It is important to note that multiple corporations may be used with 85(2), but may not be used

with 85(3)38

. Rather, the provisions of 85(3) permit transfer to “a” corporation. This provision

is not a method that may be used to divide partnership assets. Peter McQuillan and James

Thomas note39

, “If a partnership transfers its assets to a corporation under subsections 85(2) and

85(3), a subsequent attempt to butterfly those same assets from the resulting corporation will not

be ruled upon favourably and the transfer from the partnership to the corporation will be held to

be an offensive transfer in contemplation of a butterfly (see section 55(3.1)(b))”. At the end of

the day, the partners are still conducting business in one entity.

Transfer to the Partners

Where the partners wish to transfer assets from a partnership, to themselves, directly, they may

achieve this either through a taxable event, pursuant to subsection 98(2) or on a tax-deferred

approach pursuant to subsection 98(3). Alternatively, if one partner desires to continue the

business as a proprietorship, subsection 98(5) may be used. Each of these provisions is

discussed separately, below.

Subsection 98(2) provides that where partnerships have disposed of property to a partner, the

partnership shall be deemed to have disposed of the property for proceeds equal to its fair market

value, and the partner shall be deemed to have acquired the property at an amount equal to that

fair market value.

Subsection 98(3) provides an elective rollover where a Canadian partnership ceases to exist.

One non-resident partner will make access to this rollover provision unavailable.

In order for the subsection to apply, all of the partners must jointly elect, and all of the

partnership property must be distributed to the partners, such that each partner receives a pro rata

undivided interest in each property. Note that this is not a pro rata interest in each property, but

24

an undivided interest in each property. As was the case with 85(3), this provision does not allow

the former partners to operate independently after the dissolution. Depending on the assets

distributed from the partnership, some relief may be available through the “partitioning”

provisions contained in subsection 248(20). Where the assets received are shares, a

reorganization under Section 86 may achieve the desired result.

Another way this provision is similar to 85(3), is that in certain circumstances, tax implications

may result. The tax result will be dependent upon the partner‟s adjusted cost base, when

compared to the cost of the partnership property received plus the cash received.

However, unlike 85(3), subsection 98(3) may provide an opportunity to “bump” the cost amount

of certain property distributed to the partners where the particular partner‟s adjusted cost base

exceeds his proportionate amount of the partnership assets. Under paragraph 98(3)( c ), a capital

property of the partnership, other than depreciable property, can be designated by a particular

partner to have its cost to that partner increased by an amount not exceeding the adjusted cost

base of the partnership interest minus the proportionate cost amount of that partner‟s assets

received on dissolution. The “bump” cannot bring the cost amount of the particular property

above its fair market value.

This provision will be particularly useful, in circumstances where the adjusted cost base of a

partnership interest has increased due to the deemed disposition caused by the death of the

original partner. The provisions of 98(3)(c ) will permit capital assets with accrued gains to be

distributed to the holder of that partnership interest, providing an increase in the partner‟s cost

base of the partner‟s undivided interest in the particular property.

The provisions of 98(3) will not apply where subsection 98(5) applies.

Partnership Becomes Proprietorship

A partial partnership rollover is available where a Canadian partnership, becomes a sole

proprietorship, and one of the former partners continues to carry on the business40

as a sole

proprietor, within three months. Again, the existence of a non-resident partner will make this

provision inaccessible.

The rollover provisions only apply to the property that continues to be used in the business and

that was distributed to the former partner, now sole proprietor, on dissolution of the partnership.

In these circumstances, a proprietor may include a corporation. Any assets not used in the

proprietorship would be deemed disposed of at fair market value under 98(2). All other former

partners will either have proceeds of disposition if the proprietor acquires their partnership

interest or may end up with a negative adjusted cost base resulting from the distribution of

partnership property.

Similar to subsection 98(3), subsection 98(5) has a potential “bump” to the adjusted cost base of

capital property, which the proprietor uses to carry on the business. The computation of the

amount available for the bump is the same as for 98(3).

25

Subsection 98(5) does not require an election, rather it is automatic if one partner buys out all the

other partners.

Where all partners sell to one entity that was not previously a partner, the subsection does not

technically apply. Consideration should be given to the purchaser becoming a partner, prior to

the purchase. That said, depending on the facts, GAAR could be a concern with this strategy.

Similar to when assets were transferred into the partnership, care should be taken when assets are

being transferred out of the partnership, to ensure that the “stop-loss” provisions do not cause

unexpected results. These provisions, and how they apply to partnerships were discussed earlier,

so will not be discussed further.

Because of the difficulty in separating assets contained within a partnership, where

circumstances warrant, consideration should be given to establishing multiple partnerships. This

may make the division of an estate between family members, simpler, in the long run.

PLANNING OPPORTUNITIES

Various planning opportunities are discussed throughout this paper, but are highlighted here, in

summary form.

Partnerships are a vehicle, which may be used to perform estate freezes, where real

property inventories are involved. Unlike subsection 85(1), which does not permit a

rollover of real property inventory to a corporation, subsection 97(2) permits real

property inventory to be transferred on a rollover basis to a partnership.

If partnership interests are held in a discretionary family trust, as opposed to directly by

family members, more flexibility for income splitting and related planning may exist.

Discretionary family trusts permit income allocations at the discretion of the trustees, and

are not subject to the discretion available to CRA in subsections 103(1) and 103(1.1)

Transfers to partnerships under 97(1) at fair market value may permit crystallization of

losses carried forward.

Structuring with a partnership may mitigate exposure to “kiddie-tax” provisions.

An individual may transfer shares of a qualified small business corporation to a

partnership pursuant to subsection 97(2), receive partnership units in exchange, and elect

at an amount that would optimize his capital gains deduction. This amount would

increase his adjusted cost base of the partnership unit. If the partnership had cash from

other sources, or once the partnership generates cash flow, the partner may withdraw

funds from the partnership, up to the amount of his adjusted cost base, without causing

additional tax implications. This result is very different from the results that would occur

if the same transaction were conducted in a corporate environment, with the provisions of

section 84.1 being applicable. Caution should be exercised when implementing this

26

strategy, giving consideration to comments previously made with respect to the Stursberg

case.

Partnerships are not subject to the “double taxation” implications that typically apply to

corporations on the death of an individual.

A taxpayer may enter into multiple partnerships. Partnerships are not subject to the

provisions of subsection 104(2), which will deem a trust to be treated as one trust for tax

purposes, in circumstances where there is more than one trust, substantially all of the

property has been received from one person and income from the trusts will ultimately

accrue to the same beneficiaries.

On winding-up, partners may be able to “bump” cost base of assets received.

CONCLUSION

While not providing the certainty of a corporate freeze, a partnership freeze may be used to

effectively accomplish the majority of an individual‟s objectives.

Exposure to potential income reallocations will need to be managed during the structuring of the

freeze.

Where this exposure can be minimized, a partnership freeze will provide flexibility, planning

opportunities, and will avoid effective “double taxation” on windup after death.

27

BIBLIOGRAPHY

1 The author would like to thank Elise Rees and Pearl Schusheim for their editorial comments and assistance, as well

as their personal support during the preparation of this paper.

2 Income Tax Act, R.S.C. 1985 5

th Supplement, (all references in this document to sections, subsections, paragraphs,

or subparagraphs, pertain to the Income Tax Act as described herein)

3 Douglas S. Ewens, QC, “Tax Issues Affecting Partnerships”, 1997 Conference Report

4 IC-88-2, “General Anti-Avoidance Rule: Section 245 of the Income Tax Act”, paragraph 22

5 Loyens et al v The Queen, 2003 TCC 214

6 IT-413R, “Election by Members of a Partnership under subsection 97(2)”, paragraph 2

7 Peter McQuillan of KPMG and James P. Thomas of Pricewaterhouse Coopers, Understanding the Taxation of

Partnerships, 4th

Edition,1999, paragraph 620, “How to Make an Election Under Subsection 97(2)”

8 Haro Pacific Enterprises Limited v The Queen, 90 DTC 6583 (FCTD), Stursberg v The Queen, 93 DTC 5271

(FCA), Pinot Holdings Ltd v The Queen, 96 DTC 1277 (TCC), MDS Health Group Limited v The Queen, 97 DTC

5009 (FCA), Vantem Holdings Ltd et al v The Queen, 98 DTC 1335 (TCC), Manji v The Queen, 99 CTC 2220

(TCC)

9 “Revenue Canada Round Table”, 1980 Conference Report, Question 13

10

“Revenue Canada Round Table”, 1981 Conference Report, Question 45

11

Cy M. Fien, “A Review of Some Recent Approaches to Butterfly Transactions and Real Estate Restructuring”,

1994 Conference Report

12

supra footnote 2

13

IT-90, “What is a Partnership”, paragraph 2

14

Partnership Act of Alberta, RSA 2000

15

supra footnote 14

16

supra footnote 2

17

supra footnote 11

18

Continental Bank Leasing Corporation v. The Queen, (98 DTC 6505) (SCC)

19

Peter E. McQuillan, FCA, “Some Important Issues in Partnerships in the Past Year”, 2002 Conference Report

20

“Revenue Canada Round Table”, 1992 Conference Report, Question 13

21

Income Tax Rulings Directorate Documents, Document No. 9228690, “Use of Partnership for Estate Freeze”,

November 25, 1992

22

supra footnote 7, Paragraph 208, “Allocation of Income Among the Partners”

28

23

Interpretation Bulletin 231-R2, “Partnerships – Partners not Dealing at Arm’s Length”, March 3, 1986,

paragraph 3

24

supra footnote 3

25

Fraser et al v The Queen, 1997 (TCC)

26

supra footnote 23, paragraph 4

27

supra footnote 3

28

IT-81R, “Partnerships – Income of Non-Resident Partners”, paragraph 4

29

Income Tax Rulings Directorate Documents, Document No. E-70442, “Disposition of Partnership Property by

Non-Resident Partners”, May 1, 1990

30

IC-72-17R4, “Procedures Concerning the Disposition of Taxable Canadian Property by Non-Residents – Section

116”, paragraph 10

31

supra footnote 7, Paragraph 610, “‟Canadian Partnership‟: What it Means and When It Matters”

32

“Guide for the Partnership Information Return”, 2003

33

supra footnote 7

34

IT-326R3, “Returns of Deceased Persons as ‘Another Person’”, paragraph 1

35

IT-430R3, “Life Insurance Proceeds Received by a Private Corporation or a Partnership as a Consequence of

Death”, paragraph 7

36

supra footnote 7, paragraph 705, “Transfer of Partnership to a Corporation: Subsections 85(2) and 85(3)”

37

IT-378R, “Winding-Up of a Partnership”, paragraph 3

38

Income Tax Rulings Directorate Documents, Document No. E2001-0071495, “Partnership One Corporation

Rollover, May 29, 2002

39

supra footnote 7, paragraph 707, “Butterflying Assets”

40

Income Tax Rulings Directorate Documents, Document No. 910971, “Sole Proprietorship Where Previously

Carried on as a Partnership”, June 7, 1991