17 May 1990 Administrative Letter 59006 F - Partnership as Tax Shelter

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the CRA.
Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'ARC.

May 17, 1990

Dear Sirs:

Re:  Section 237.1 of the Income Tax Act (the "Act")

We are writing in response to your letter of October 30, 1989 in which you requested our opinions regarding the application of section 237.1 of the Act to the hypothetical situation described below.

Confirmation of the tax consequences of proposed transactions is only provided in response to a request for an advance income tax ruling, as described in our Information Circular 70-6R dated December 18, 1978.  Although we are unable to provide any binding confirmation in response to your request, we have stated below some general comments.

Further to our conversation of February 7, 1990, our understanding of the hypothetical situation is as follows:

1.     An individual, Mr. A, buys an interest in AB Partnership, a newly formed limited partnership, for $100.

2.     Mr. A is the only limited partner in the partnership, while another individual, Mr. B, is the only general partner.

3.     Mr. A was approached personally by Mr. B to invest in this partnership.  Mr. A purchases his partnership interest based on Mr. B's personal recommendation.

4.     Pursuant to the partnership agreement, Mr. A will be allocated a percentage of profits and losses; however he is entitled to drawings from the partnership equal to a percentage of the gross revenue of the limited partnership even though no net income may be generated.

5.     In year 1 of the partnership, the partnership will carry on a business and, in so doing, expend the $100 which Mr. A contributes for his partnership interest.  No revenue will be generated in year 1 so Mr. A will be allocated a loss of $100, being his share of the partnership's total loss.

6.     In year 2 of the partnership, it is anticipated that the partnership will realize revenue but also incur expenses which will result in a net profit of nil.  Therefore no profit or loss will be allocated to Mr. A; however he will receive $50 from the partnership pursuant to his entitlement to drawings based on gross revenue.

You queried whether section 237.1 of the Act would apply in such a situation.

Our Comments

In order for the partnership to be considered to be a tax shelter, one must regard "statements or representations made or proposed to be made in connection with the property," according to the definition of tax shelter in subsection 237.1(1).  The wording is intentionally broad enough to encompass verbal suggestions and not just written representations.  If Mr. B had indicated to Mr. A that, within 4 years after the time Mr. A were to acquire his interest, there would be an Excess Amount (where the Excess Amount is the amount by which the aggregate of his losses and other deductible amounts would exceed his Reduced Cost (where Reduced Cost means the amount by which his cost would exceed the amount of the prescribed benefits)), the partnership would be a tax shelter. This would be so notwithstanding that Mr. A may be financing the development of a business which is of interest to him as an investment rather than as a potential tax shelter.

As you noted in your letter, Mr. A would have a "negative adjusted cost base" of his partnership interest in the amount of $50 at the end of year 2, since the deductions per paragraph 53(2)(c) of the Act would exceed the additions per paragraph 53(1)(e) by that amount.  However, the "cost" referred to in the definition of tax shelter is the taxpayer's laid-out cost for his partnership interest rather than the adjusted cost base of his partnership interest.  (An exception to using laid-out cost would be where the Act deems the cost to be an amount other than actual cost.)  Presuming for the moment that there would be no amounts deductible by Mr. A other than his share of partnership losses and that there are no prescribed benefits, at the end of year 2 there would be no Excess Amount by calculation.  However, one must also consider what Mr. A's loss expectations would have been, at the outset, for each of the first four years.  If Mr. B held out to Mr. A that his losses for the first four years would equal but not exceed his original cost, then the partnership would not be a tax shelter.  If, however, Mr. B indicated to Mr. A that his carrying costs with respect to his partnership interest would also be deductible, that would result in an Excess Amount and the partnership would be a tax shelter.

Since there is no revenue guarantee or other agreement in respect of which revenue may be earned by Mr. A, you concluded that there is no prescribed benefit.  However, according to the definition of "prescribed benefit" which was added to the Income Tax Regulations on October 26, 1989 as subsection 231(6) thereof, a prescribed benefit includes more than just revenue guarantees.  Paragraph (a) thereof refers to an amount owed by the purchaser or a person with whom the purchaser does not deal at arm's length, subject to certain exceptions.  In your example, Mr. A will be entitled to withdraw funds from the partnership in excess of his earned revenue.  If, for instance, the excess withdrawals constitute an amount owing to the partnership and Mr. A is not required to repay this excess amount or there is limited recourse which can be taken against him, the amount owed would constitute a prescribed benefit.  In the hypothetical case described above, this would cause the partnership to be viewed as a tax shelter.

Our comments in this letter represent our general views with respect to the subject matter of your letter.  The facts of a particular situation may lead to a different conclusion.  Our comments in this letter are not rulings and, in accordance with the guidelines set out in Information Circular 70-6R dated December 18, 1978, are not binding on the Department.

Yours truly,

for DirectorBusiness and General DivisionSpecialty Rulings DirectorateLegislative and Intergovernmental Affairs Branch