27 July 1990 Ruling 59513 F - Immediate Withdrawal of Funds Contributed to Partnership on Tax-deferred Basis

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.

Attention: 19(1)

July 27, 1990

Dear Sirs:

Re:  Subsection 97(2) of the Income Tax Act (the "Act") and the Application of Subsection 245(2) of the Act

We are writing in reply to your letter of January 24, 1990 wherein you requested a technical interpretation of the application of subsection 245(2) of the Act with respect to hypothetical situations involving the immediate withdrawal of funds from a partnership by a partner who transferred property to the partnership on a tax-deferred basis pursuant to subsection 97(2) of the Act.  The funds withdrawn are contributed by an unrelated partner.

In particular, you have requested technical interpretations involving different scenarios based on the premise that Mr. A owns real estate inventory that he wishes to develop into houses for resale.  As Mr. A does not have the expertise to see the development through himself, he will form a partnership with Mr. B.  However, Mr. A will be an active partner in all scenarios.

SCENARIO I

1)     Mr. A will transfer his real estate inventory (having a fair market value of $3.0M) to the partnership in return for a 50% interest in the partnership and the assumption by the partnership of a related mortgage of $0.8M.  An election will be made pursuant to subsection 97(2) of the Act to have the real estate inventory transferred to the partnership at its adjusted cost base of $1.0M so that no tax will be paid by Mr. A with respect to the transfer.

2)     Mr. A's partnership interest will amount to $2.2M which represents the fair market value of the property transferred net of the mortgage which is assumed by the partnership.  The adjusted cost base of Mr. A's partnership interest is $0.2M, being the excess of the elected amount over the mortgage assumed.

3)     Mr. B contributes $2.2M cash to the partnership in return for a for a 50% partnership interest.  At this point, the initial capital ratios based on fair market values for each of Mr. A and Mr. B will be 50:50.

You are requesting a technical interpretation on the application of subsection 245(2) of the Act with respect to the immediate cash withdrawal from the partnership by Mr. A of $0.2M (the adjusted cost base of his partnership interest), $1.0M (the adjusted cost base of the property transferred to the partnership), or $1.6M (half of the fair market value of the partnership assets).

SCENARIO II

1) and 2)  from Scenario I are the same.

3)      Mr. B contributes $1.0M in cash to the partnership plus his expertise for a 50% partnership interest.

You are requesting the same technical interpretation as for Scenario I on the application of subsection 245(2) of the Act with respect to the immediate cash withdrawal from the partnership by Mr. A of $0.2M (the adjusted cost base of his partnership interest), $1.0M (the adjusted cost base of the property transferred to the partnership), or $1.6M (half of the fair market value of the partnership assets).

SCENARIO III

1)     Same as 1) in Scenario I except that the partnership does not assume the mortgage.

2)     Mr. A's partnership interest will amount to $3.0M which represents the fair market value of the property.  The adjusted cost base of Mr. A's partnership interest is $1.0M.

3)      The partnership places a $0.8M mortgage on the property.

You are requesting a technical interpretation of the application of subsection 245(2) of the Act with respect to the immediate cash withdrawal from the partnership by Mr. A of $0.8M which will reduce the adjusted cost base of Mr. A's partnership interest to $0.2M and which Mr. A will use to pay-off the original mortgage.

You are also requesting a technical interpretation of the application of paragraph 20(1)(c) of the Act as it applies to the interest incurred on the mortgage entered into by the partnership given that the mortgage funds will be used to make a distribution of capital that was used by the partnership for a qualifying purpose.

SCENARIO IV

This Scenario is the same as Scenario III, except that the mortgage on the property retained by Mr. A is $1.2M.  When Mr. A withdraws the $1.2M to pay-off the original mortgage, this will reduce the adjusted cost base of his partnership interest to negative $0.2M with no capital gain to be realized pursuant to subsection 40(3). You are requesting the same technical interpretations as in Scenario III.

OUR COMMENTS

There would be many factors to be considered in making any determination on the application of GAAR to a particular case.  However, we offer the following general observations on the limited facts provided.

With respect to situations such as those described in the Scenarios above, the Department is concerned where a rollover of property to a partnership under the provisions of subsection 97(2) is accompanied by an immediate cash withdrawal.  Though such determination is a question of fact to be resolved after a review of all the relevant circumstances, it is arguable that the transfer of the real estate inventory into the partnership under subsection 97(2) constitutes an avoidance transaction.  The subsequent withdrawal of cash appears to complete a series of transactions which would result in a tax benefit pursuant to paragraph 245(3)(b).  The primary purpose for the transaction seems to be the achievement of a tax benefit, especially where the cash is withdrawn shortly after the creation of the partnership.  The amount of the cash withdrawal is not crucial to this determination although the larger the withdrawal, the greater the tax benefit.  It is arguable that this series of transactions would result in a misuse of the rollover provisions in subsection 97(2) and an abuse of the Act read as a whole, with section 43 in mind.  In such a case, in the above Scenarios we would view any cash back to Mr. A as proceeds of disposition of the real estate inventory.

In addition, with respect to Scenario II, as supported by Stursberg et al 90 DTC 1159, the Department may consider the cash back as a sale by Mr. A of part of his partnership interest.  In order to make such a determination, the Department would need to consider Mr. B's expertise and whether it warranted an 18.75% interest in the partnership.  If not, it is probable that Mr. A would be seen as having sold part of his partnership interest for proceeds equal to the immediate cash back.  The Department would maintain in the above Scenarios, where unlike the Stursberg case where the cash back was accompanied by a reduction in the partnership interest, that without the immediate cash back that Mr. A  would have received a greater partnership interest.

With respect to the deductibility of interest on mortgages incurred by the partnership in Scenarios III and IV above, where the Department determines that GAAR applies to redetermine the tax consequences to reflect a disposition by Mr. A of his real estate property, then the interest would be deductible by the partnership pursuant to subparagraph 20(1)(c)(ii) as interest paid on an amount payable for property acquired for the purpose of gaining and producing income from a business.  Should it be determined that GAAR does not apply, then such interest would be deductible pursuant to subparagraph 20(1)(c)(i) under the Notice of Ways and Means Motion tabled on November 24, 1989 which extends our current administrative practice to borrowing before 1991 by a partnership to make a distribution of capital to the extent that such capital was used by the partnership for a qualifying purpose.

We trust that these comments will be of assistance.

R.E. Thompson for DirectorBusiness and General DivisionRulings DirectorateLegislative and Intergovernmental Affairs Branch