30 August 1990 Administrative Letter 59796 F - Allocation of Partnership Income

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)

August 30, 1990

Dear Sirs:

Re:  Request for Technical Interpretation Paragraphs 96(1)(d) and (g) and Section 103 of the Income Tax Act (the "Act")

We are writing in reply to your letter dated March 19, 1990 wherein you requested a technical interpretation in connection with a hypothetical situation in which arm's length partners agree to allocate partnership income and loss.

Hypothetical Situation

The salient points of the hypothetical situation which you described in your letter may be summarized as follows:

1.     A partnership will be constructing and operating a facility that will involve expenditures on Canadian resource properties which qualify as Canadian oil and gas property expenses  ("COGPE" as defined at paragraph 66.4(5)(a) of the Act), depreciable property and operating expenses.

2.     The relevant parties are referred to as Partner A, Subco (a wholly-owned subsidiary of Partner A) and Partner B.  Partner B deals at arm's length with Partner A and Subco.

3.     Partner A, Subco and Partner B will agree, in the partnership agreement to be entered into among them, that partnership income, loss and COGPE will be allocated immediately before the end of each fiscal year of the partnership on the basis of each partner's adjusted cost base ("ABC" as defined at paragraph 54(a) of the Act) of the relevant partnership interest.

4.     Partner A and Subco will form the partnership and Partner B will be admitted to the partnership during the partnership's second fiscal period.  Subco will have no material assets or liabilities, its role being to join with Partner A to create the partnership.

5.     In the partnership's first fiscal year, Partner A will contribute Canadian resource properties having a fair market value of $10,000,000 to the partnership pursuant to subsection 97(1) of the Act.  Shortly thereafter the partnership's first fiscal year will end.

6.     Immediately before the end of the partnership's first fiscal year, Partner A's ACB will be $10,000,000 and Subco's will be $1.00.

7.     During the partnership's second fiscal year, Partner B will, upon admission to the partnership, contribute ash and depreciable property of $400,000 and $2,000,000 respectively. Immediately before the end of the second fiscal year, Partner B's ACB will be $2,400,000 and Partner A's will be $nil.

8.     During the partnership's third fiscal year, Partner B will contribute cash and depreciable property of $600,000 and $7,000,000 respectively.  Consequently, the total contributions by Partner A and Partner B during the three fiscal periods would be $10,000,000 each.

9.     As noted in 6 above, immediately before the end of the partnership's first fiscal year, Partner A's ACB will be $10,000,000 and Subco's will be $1.00.  Accordingly, the  entire $10,000,000 of COGPE of the partnership will be   allocated to Partner A.  Immediately before the end of the partnership's second fiscal period, the ABC of Partner A will be nil and of Partner B will be $2,400,000. Accordingly, 100 percent of partnership's non-capital loss sustained in its second fiscal year, but not to exceed $2,400,000, will be allocated entirely to Partner B.  Immediately before the end of the partnership's third fiscal period, Partner A's AC8 will still be nil and Partner B's ACB will be the amount by which its total contributions up to that time ($10,000,000) exceed the non-capital loss of the partnership allocated to Partner B at the end of the partnership's second  fiscal year. Accordingly, the entire net loss of the partnership for its third fiscal year, but not exceeding the amount by which $10,000,000 exceeds the partnership's loss for its second fiscal year which was allocated entirely to Partner B, will be allocated to Partner B. To the extent that any net losses are sustained by the partnership in its third or any subsequent fiscal year in excess of Partner B's ACB immediately before the end of such year, they will be shared equally between Partner A and Partner B.

Your Submission

It is your view that a particular partner's "share" of a loss (or other tax attribute capable of allocation under the Act, e.g. COGPE) of a partnership, within the meaning of paragraph 96(1)(g) (or, in the case of COGPE, subparagraph 66.4(5)(a)(ii)) of the Act, may be computed by "tracing" the precise source of such loss to particular properties contributed to the partnership by each partner.  In other words, a partner's share of the partnership's loss is not invariably required to be apportioned according to the value of his initial contribution expressed as a percent of the value of all partners' initial contributions.

You have also submitted that the Act's lack of a strictly mathematical formula to determine each partner's "share" of a partnership's income or loss is a result of Parliament's desire that the income tax treatment reflect, to the extent reasonable, the business terms reached by arm's length partners as to their allocation thereof.

Our Comments

Existence of Partnership

It would be a question of fact whether or not there would be a partnership as a result of Subco's arrangements with Partner A.  It is stated at paragraph 2 of Interpretation Bulletin IT-90 that generally speaking, a partnership is the relationship that subsists between persons carrying on business in common with a view to profit.  However, co-ownership of one or more properties not associated with a business, does not itself create a partnership, and this is so regardless of an arrangement to share profits and losses.  Reference would be made to the applicable provincial law on the subject.

It is not clear that the "partnership" of Partner A and Subco is a relationship that subsists between persons carrying on business in common with a view to profit.  A respectable argument may be made that the "partnership" of Partner A and Subco merely owns the Canadian resource properties, which under "common law" might be a joint tenancy; no business is carried on until Partner B contributes the depreciable properties and cash which, in conjunction with the Canadian resource properties, would constitute the business.

Thus, without expressing any opinion thereon, a partnership may not exist as a result of Subco's "joining" with Partner A.  Rather, the partnership may be created at the time when contributions by Partner A and Partner B are made.

Furthermore, as stated at paragraphs 1 and 2 of IT-338R, examination of all of the relevant partnership provincial law and the partnership agreement with Partner B, may lead to a conclusion that a new partnership is created by the admission of Partner B and that the "partnership" of Partner A and Subco was liquidated immediately before the admission of Partner B.  In this case, Partner A's ACB of its partnership interest at the time of admission of Partner B would be $10 million for purposes of allocating income, losses or COGPE, as the case may be, not $ nil as suggested in the hypothetical situation.

Since all of the information, including the relevant partnership agreements, which are necessary to make the foregoing determinations have not been provided, we are unable to provide an opinion on when or whether a partnership exists in your hypothetical situation.

Section 103

We acknowledge that the provisions of the Act do not require a partner's share of a partnership's loss to be apportioned according to the value of his initial contribution expressed as a percent of the value of all partners' initial contributions. 

We cannot find any support in the available literature or anywhere else to support your contention that the absence of a mathematical formula in the Act by which partnership income may be allocated is a result of Parliament's desire that the income tax treatment should reflect, to the extent reasonable, the business terms reached by arm's length partners as to their allocation of partnership income.  We do not, however, disagree with your contention.

It is our view that, generally, where arm's length partners agree to share partnership income on a particular basis (whether the partners' ACB, the precise nature of the property contributed to the partnership by partners, or some other basis) and the resulting amounts allocated to partners are reasonable and the agreement may not reasonably be considered to be for the reduction or postponement of the tax that might otherwise have been or become payable under the Act such that subsection 103(1) of the Act does not apply, such agreement to share partnership income or loss would be acceptable for income tax purposes.

With respect to the hypothetical situation involving Partner A, Subco and Partner B, we are unable to opine on whether subsections 103(1) or (1.1), as the case may be, would apply because the facts are not sufficient to determine whether the amounts allocated are reasonable or whether the principal reason for the agreement may reasonably be considered to be the reduction or postponement of tax that might otherwise have been or become payable under the Act.

As alluded to above, it may be that no partnership exists except by the contributions of Partners A and B which, in the aggregate and not by themselves, would create a business.  In this case, without expressing any opinion whether section 103 would apply, allocations of the partnership's COGPE, income or loss, as the case may be, on the basis of ABC would result in allocations according to Partner A's ABC of $10,000,000 and Partner B's ACB of $2,400,000.  Partner B's subsequent contributions totalling $7,600,000 would affect the allocations based on ABC, mutatis mutandis.

Farmout

The hypothetical situation appears to be similar to a widespread farmout arrangement whereby a farmee, Partner B, would acquire an interest in a farmor's, Partner A's, Canadian resource property and in consideration for such interest, Partner A would receive, inter alia, an interest in Partner B's depreciable property.

The Department's position with respect to these farmout arrangements is that Partner A would be considered to have acquired the interest in the depreciable property at an amount equal to its fair market value and to have disposed of an interest in the Canadian resource property for that amount, where the fair market value of the Canadian resource property cannot be determined. 

The results of such a farmout situation would be a reduction of Partner A's cumulative COGPE and an addition to the relevant undepreciated capital cost ("UCC") with respect to the disposition of the Canadian resource property and the acquisition of the  depreciable property, respectively.

It appears that these results may not be obtained as a consequence of the transactions involving a partnership contemplated in the hypothetical situation.  In this regard, we note the following statement by the Supreme Court in The Queen v. Bronfman Trust, 87 DTC 5059, at 5067

     "Assessment of taxpayers transactions with an eye to commercial and economic realities, rather than juristic classification of form, may help to avoid the inequity of tax liability being dependent upon the taxpayer's sophistication at manipulating a sequence of events to achieve a patina of compliance with the apparent prerequisites for a tax deduction."

Where the Department's position with respect to farmout arrangements as described in IT-125F3 has been avoided by the sequence of events contemplated in the hypothetical situation, the Department would seek to apply the general anti-avoidance provision in the Act. 

Carved-Out Property

The hypothetical situation may also invoke the provisions of section 209 in Part XII.1 of the Act, known as the tax on carved-out income, where the Canadian resource property contributed by Partner A is a producing property.

Generally, tax is exigible on a taxpayer's carved-out properties pursuant to subsection 209(2) of the Act.

Carved-out property is defined at subsection 209(1) of the Act generally as a Canadian resource property as this term is defined at paragraph 66(15)(c) of the Act.

Notwithstanding that it is our view that partnership interests are not Canadian resource properties and therefore cannot constitute carved-out property under paragraph 209(1)(a) of the Act, the hypothetical situation would nonetheless appear to involve the situation contemplated in the definition of carved-out property at subparagraph 209(1)(a)(iii) of the Act, i.e., where either partner's income which would otherwise be attributable to the Canadian resource property but for the partnership, would be substantially reduced within 10 years following acquisition of the partnership interests.

If one of the main reasons for the existence of the partnership interests in the hypothetical situation is to reduce or postpone Part XII.1 tax, then the partnership interest would be classified as carved-out property pursuant to paragraph 209(1)(b) of the  definition of carved-out property for the purposes of applying the Part XII.1 tax under subsection 209(2) of the Act.

If the hypothetical situation which you described involves definite proposed transactions of particular taxpayers, an application for an advance income tax ruling may be appropriate.

The above comments are merely the expressions of opinion of those Revenue Canada officials named herein and as such should not be construed as advance income tax rulings, nor are they binding on the Department. Our practice is to make this specific disclaimer in all instances in which we provide an opinion.  We refer you in this respect to paragraphs 21 and 24 of Information Circular 70-6R.

Yours truly,

Section ChiefResource Industries SectionBilingual Services and ResourceIndustries DivisionRulings Directorate