Taxation of Partnerships Under Subsection 96(1) of the Income Tax Act –
A Canadian Tax Lawyer Analysis
Introduction: The Partnership Act (Ontario) and Private Law Rules
Under section 2 of the Partnership Act (Ontario), a partnership is defined as the relationship that coexists “between persons carrying on a business in common with a view to profit”. Section 3 of the Partnership Act (Ontario) sets out the rules for determining whether (or not) a partnership exists:
- The existence of “joint tenancy, tenancy in common, joint property, common property, or part ownership” does not create a partnership, regardless of whether (or not) the tenants or owners of the relevant property, share (or do not share) profit made by the use of that property;
- The “sharing of gross returns” does not in itself create a partnership regardless of whether (or not) the persons sharing such returns have (or have not) a joint or common right or interest in any property from which or from the use of which the returns are derived;
- In the absence of evidence to the contrary, a person’s receipt of a share of the profits of a business is proof that the person is a partner in the business. However, the receipt of such profit, share or payment, does not of itself make the person a partner in the business. In particular:
- A person’s receipt of debt or instalment payments out of profit accruing from a business does not make the person a partner of the business, nor does it make the person liable as such;
- A contract for renumeration of a servant, agent or a person engaged in a business by way of shared profits from the business does not make the servant, agent or person a partner of the business, nor does it make the person liable as such;
- A person is not a partner of the business nor is the person liable as such if she or he receives an annuity payment from profit made in a business where the person was (i) married to a deceased partner immediately before the deceased partner died; (ii) living with a deceased partner in a matrimonial relationship immediately before the deceased partner died; or (iii) a child of a deceased partner.
- A loan advanced to a person who is engaged in a business or is about to engage in a business under a contract where the lender is entitled to receive a share of the profits arising from carrying on the business or a rate of interest that is contingent on the profit of the business, does not constitute a partnership between the person and the lender; and,
- A person receiving an annuity or a partial payment of the profits of a business in consideration for his or her sale of the goodwill of the business, is not by reason of such receipt a partner or liable as such.
The Personal Liability in A Partnership
The general rules for liability in a partnership are set out in section 10 of the Partnership Act (Ontario). Subsection 10(1) stipulates that “every partner is liable jointly with the other partners for all debts and obligations of the firm incurred while the person is a partner, and after the partner’s death the partner’s estate is also severally liable” for outstanding debts and obligations.
However, the following types of partnerships are significant for income tax purposes:
- limited partnership;
- Canadian partnership;
- professional partnership; and
- specified investment flow-through partnership.
Ontario’s Limited Partnership Act section 9 provides that a partner in a limited partnership is not liable for the obligations of any partner of the limited partnership except in respect of their contributions, such as money and property, to the limited partnership. In this context, a partner in a limited partnership is liable for debts only to the extent of his or her capital contribution to the partnership. Further, pursuant to subsection 2(2) of the Limited Partnership Act, a limited partnership must have one or more general partners who are liable for the partnership debts without limitation and one or more partners who are limited partners.
Subsection 102(1) of the Income Tax Act sets out the definition for a “Canadian partnership” which is one in which all of its members are resident in Canada. In this context, the transfer of property to and from a partnership to its partners is permitted on a tax-free rollover basis.
Ontario’s Partnership Act permits professionals, such as lawyers, to practice in limited liability partnerships provided that (1) the partnership registers its name under the Business Names Act; (2) the act governing the profession permits the practice of the profession under a limited liability partnership business structure; and, (3) the governing body of the professional requires the partnership to maintain a minimum amount of liability insurance (Partnership Act, section 44.2). Upon approval of the Law Society of Ontario, lawyers and paralegals practicing law in Ontario may be permitted to form a multi-disciplined partnership with other professionals in other professions including, but not limited to, accountants and tax consultants.
Pursuant to subsection 197(1) of the Income Tax Act, a specified investment flow-through partnership (also knowns as SIFT partnership) is (a) a Canadian-resident partnership (b) that holds “non-portfolio property” where (c) the investments in the partnership are listed for trade on a stock exchange or other public market. The specified investment flow-through partnership rules were precisely designed to define the tax treatments of income trusts. Consequently, the specified investment flow-through partnership rules effectively tax such partnership and trust entities as a corporation.
Advantages and Disadvantages of Partnerships
The advantages of partnerships include, but are not limited to:
- partners benefit from the flow through of income and losses incurred at the partnership level;
- income is only taxed in the hands of the partner;
- a partner can deduct losses from a partnership against income earned outside of the partnership;
- partners can maintain ownership and control over the business;
- low start-up costs;
- tax-free rollover on the transfer of property from the partnership to its partners, as per the above-mentioned definition of Canadian partnerships; and,
- increase in the number of partners could increase the business’s capital.
In contrast, the disadvantages of partnerships include, but are not limited to:
- a partnership is not entitled to the low tax rates available for active business income; and,
- a partnership does not benefit from the limited liability and tax advantages available to corporations.
Partnerships and the Income Tax Act
Canada’s Income Tax Act does not define the term “partnership”. Under section 96 of the Income Tax Act a partnership is not a person, but partnership income is calculated as though it were (a person) for income tax purposes. Consequently, partners in a partnership report the income or losses of the partnership on their personal income tax returns.
A partnership does not file annul income tax returns. However, pursuant to subsection 229(1) of the Income Tax Regulations, partnerships in a partnership that carries on business in Canada or a Canadian partnership with Canadian or foreign investments are required to file an information return on behalf of the partnership.
Partnerships and Subsection 96(1) of the Income Tax Act
Subsection 96(1) of the Income Tax Act sets out the rules pertaining to the computation and flow through of partnership income and losses to its partners. Under subsection 96(1), income and losses of a partnership are computed first at the partnership level, then allocated between each member of the partnership based on his or her share of the partnership.
According to subsection 96(1) of the Income Tax Act, a taxpayers’ income or losses from a partnership shall be computed as if:
- The partnership was a separate person resident in Canada;
- The tax year of the partnership were its fiscal period;
- Each partnership activity was carried on by the partnership as a separate person and a computation was made of the amount of the:
- taxable capital gains and allowable capital loss of the partnership arising from the disposition of property; and,
- income and losses of the partnership from each other source or from sources of a particular place.
for each taxation year of the partnership:
- the amount of the income of the partnership for a taxation year [..] were the income of the taxpayer [..], for the taxation year of the taxpayer’s in which the partnership’s taxation year ends, to the extent of that taxpayer’s share thereof; and,
- the amount of the losses of the partnership for a taxation year [..] were the loss of the taxpayer [..], for the taxation year of the taxpayer’s in which the partnership’s taxation year ends, to the extent of that taxpayer’s share thereof.
Despite the fact that a partnership is not recognized as a separate legal entity under the Partnership Act (Ontario), section 96 of the Income Tax Act provides for a hypothetical computation of income or losses as if the partnership was in fact a separate legal entity. Further, the flow through of income and losses to the partners is contingent on their share of the partnership.
Pro Tax Tips – Partnerships
A partnership can be a significant and flexible tool for achieving effective business and tax planning objectives. However, partnerships are a complex area of law that require detailed analysis and advice from an experienced Canadian tax lawyer. If you are considering creating or engaging in a partnership, you should consider obtaining advice from an experienced Canadian tax lawyer on how the above-mentioned rules may impact your tax planning objectives and business structure. If you have questions pertaining to partnership rules under the Income Tax Act, please contact our tax law office to speak with one of our experienced Certified Specialist in Taxation Canadian tax lawyers.
"This article provides information of a general nature only. It is only current at the posting date. It is not updated and it may no longer be current. It does not provide legal advice nor can it or should it be relied upon. All tax situations are specific to their facts and will differ from the situations in the articles. If you have specific legal questions you should consult a lawyer."