A Canadian Tax Lawyer’s Analysis of Income Tax Act Subsection 40(3.1)

Partnerships and their partners are subject to a number of unique Canadian taxation rules which may catch taxpayers off guard and cause them to incur tax penalties. One of these rules is the negative adjusted cost base rule found at subsection 40(3.1) of the Income Tax Act. Subsection 40(3.1) deems a limited partner or specified member of a partnership to have incurred a capital gain when the ACB of their partnership interest is negative.

Adjusted Cost Base of a Partnership Interest

Partnerships are flow through entities for taxation purposes. Instead of the partnership income and losses being taxed at the partnership level, these losses and income are apportioned to the partners and taxed as part of their personal income taxes. The adjusted cost base of a partnership interest is the book value of the partnership interest, calculated according to subsection 40(3.11), subsection 53(1) and 53(2) of the Income Tax Act for the purposes of subsection 40(3.1). In simple terms, the adjusted cost base is equal to the initial investment plus the partner’s share in partnership profits and any capital contributed by the partner minus the partner’s share of partnership losses and any draws the partner has taken from the partnership.

Limited Partner and Specified Member

Subsection 40(3.1) applies only to limited partners and specified members of the partnership. Active members of partnership can have a partnership interest with a negative adjusted cost base without incurring the deemed gain, which means they can deduct partnership losses to reduce other sources of income.

A limited partner is defined at subsection 40(3.14) and subsection 96 (2.4) of the Income Tax Act. A partner is considered a limited partner where there exists an agreement in relation to the partnership or partnership interest which limits the liability of the partner. Though the most common instance of this will be partners who own a limited partnership interest in a limited partnership, other arrangements which limit a partner’s liability are also captured by this definition. For instance, if partners purchased a general partnership interest under an agreement that a third party would later purchase their partnership interest, thus preventing them from incurring a loss on the purchase, these partners would be limited partners.

Limited partners are always specified members of a partnership. However, a partner can be a specified member without being a limited partner. A specified member is any partner except those partners who on a regular, continuous and substantial basis throughout the portion of the year where the partnership ordinarily carries on business either are actively engaged in the activities of the partnership and/or carry on a separate but similar business to that of the partnership. If the partner’s involvement in the partnership is restricted to financing the partnership business and he or she does not carry on a similar business, he or she will also be considered a specified member. A partner is actively engaged in the business of the partnership where he or she exercises influence over the partnership’s decisions but not as an employee, contract worker or volunteer.

Subsection 40(3.1) will not apply to specified members who have been active members of the partnership at some point since becoming member, even if they would presently be considered specified members. There is one exception to this principle found at subsection 40(3.131) of the Income Tax Act which is in effect an anti-avoidance rule. Subsection 40(3.1) will still apply to specified members who are reasonably found to have acted as active members to avoid application of subsection 40(3.1).

Specified members do not actively participate in the business, or a similar business, of the partnership. Limited partners are not permitted to be involved in the management of the partnership. Subsection 40(3.1) is therefore only intended to capture taxpayers who are holding an interest in a partnership as passive investors not involved in the decision making of the partnership.

Income Inclusion From Subsection 40(3.1)

The limited partner or specified member will include the gain created by subsection 40(3.1) arising from a negative adjusted cost base (ACB) in his or her taxable income. Subsection 40(3.1) deems a disposition to have occurred making the ACB of the partnership interest nil. This deemed disposition prevents the taxpayer from being double taxed by incurring the same deemed gain in the next taxation year(s) if the ACB of his or her interest continues to be negative. Given subsection 40(3.1) creates a deemed capital gain, the income inclusion for the partner will be equal to either fifty percent of the decrease of the ACB if the ACB was negative in the pervious year, or fifty percent of the negative ACB is the ACB was positive in the previous year.

Tax Tip: Partners must be aware of the unique tax treatment of their partnerships

Taxation of partnerships can create confusion for taxpayers as partnerships are unique entities with specific taxation rules and those rules can vary depending on the partner and his or her involvement in the partnership. In particular as regards to specified members, the Canada Revenue Agency and courts have provided minimal guidance on what is considered sufficient activity to not be considered a specified member. Those investing in partnerships must consequently ensure they understand their role in the partnership and the resulting tax liability. Our certified tax specialist Canadian tax lawyer can help you figure out the tax liability arising from your partnership interest, and can assist you with disputes if the Canada Revenue Agency mistakenly classifies you as a limited partner or specified member.

About the Author

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David J. Rotfleisch

David J. Rotfleisch, a leading Canadian tax lawyer, is not only a certified specialist in taxation but also a chartered professional accountant. Most recently, David is a pioneer in Canadian crypto taxation.

As of April 2020, he was one of 12 Ontario Certified Specialists In Taxation™.

Learn more about David J. Rotfleisch