25 September 1989 External T.I. 73500 F - Computation 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.

Subject: 24(1)

This is in reply to your letter of December 2, 1988 regarding payments related to a corporate partnership.

Our understanding of the situation is as follows:

24(1)

You have asked whether subsection 17(1) of the Act is applicable in respect of the loans described in #5 above and whether paragraph 212(1)(a) or (old) subsection 245(2) of the Act applies in respect of the unreasonable amount described in #6 above.

Loans

A partnership is not a legal entity and, as such, it cannot at law make loans or own property.  However, paragraph 96(1)(a) of the Act provides that, for the purposes of calculating a partner's (e.g., Canco A and Canco B) income, taxable income earned in Canada and certain losses, a partnership is to be treated as a person (e.g., the partnership will be considered to own property, make loans, etc.).  In order to determine how much income should be attributed to the partners (Canco A and Canco B, in this case) as a result of a loan, a partnership (P/S) must be treated as if it was a separate person that made the loan.  Since, for the purposes of computing income, P/S made the loan, we cannot say that Canco A and Canco B made the loan.

Section 17 of the Act applies where "a corporation resident in Canada has loaned money".  As a partnership is not deemed by subsection 96(1) of the Act to be a corporation (it is merely deemed to be a person), section 11 of the Act would not apply to include an amount in the income of a partnership lender.  In this case, as P/S, and neither Canco A nor Canco B, made the loan, section 17 cannot be applied to Canco A or Canco B (however, section 17 could apply in very different circumstances - where a partnership is the debtor - since the section provides "loaned money to a non-resident person and a partnership is deemed a person).

The Norco Development case (85 DTC 5213) dealt with the question of whether, within the meaning of subsection 129(6) of the Act, an amount was paid by the corporate partners or by the partnership.  The Federal Court-Trial Division stated:

     "In my opinion, the partnership, Noort Developments, is not a legal entity.  Section 96 of the Act provides rules for the computation of partnership income.  The partnership is envisaged as a separate person solely for the purpose of measuring the flow of income to the individual partners, which is then taxed in their hands... it is my opinion that the plain meaning of the words "by another corporation" in subsection 129(6) is patently broad enough to reach the plaintiff is the payer of the interest to the recipient corporation, Noort Bros. Construction Ltd".

The Norco Development case is quite distinguishable from this situation.  Norco Development analyzed subsection 129(6) of the Act, which is in Division F, "Special Rules Applicable in Certain Circumstances" whereas we are concerned with section 17 of the Act, which is in Division B, "Computation of Income".  That is, subsection 129(6) of the Act deals with the computation of tax, not income or taxable income earned in Canada, so subsection 96(1) of the Act does not apply to subsection 129(6) of the Act (so, in Norco Development the partnership would not be considered a person that paid money).  Because, in this case, our concern is the computation of the income (not tax) of the partners and whether a deemed amount of interest should be included in income, the legal fiction created by paragraph 96(1)(a) of the Act (that a partnership must be treated as if it were a person) must be applied (so the partnership is considered to own the loan) with the result that section 17 of the Act does not apply to this situation.

However, if the partnership, the corporate partners or the shareholders borrowed money at interest to make the loan, the full interest deduction would not be allowed (Interpretation Bulletin IT-445).

Excessive Portion of "Management Fees"

Although it may be argued that the benefit conferred on USCo is a management fee, albeit an excessive one, and is therefore taxable under paragraph 212(1)(a) of the Act, it is our view that, since other sections of the Act are more clearly applicable and since the application of paragraph 212(1)(a) of the Act may trigger arguments by the taxpayer that the benefits are business profits to USCo and are treaty exempt (by virtue of -Article VII of the Canada-US Income Tax Convention (1980)), this would not be the most worthwhile avenue to pursue.

In our opinion, (old) subsection 245(2) of the Act clearly applies to this situation in respect of benefits (the excessive portion) conferred upon USCo before September 13, 1988 (and "grandfathered" benefits).  Accordingly, USCo would be subject to 25% Part XIII tax on the excessive portion of amounts paid to it.  With regard to the application of (old) subsection 245(2) of the Act, we refer you to the Indalex case (86 DTC 6039).  (Old) Subsection 245(2) of the Act may also be applied to Paul and Richard (who may be said to have benefited from the transfer of funds to USCo).  However, the same amount should not be taxed under both old paragraph 245(2)(a) and 245(2)(b) of the Act (that is, double taxation should be avoided).

Further, as an alternative to the application of, (old) subsection 245(2) of the Act to either USCo or to 19(1) subsection 56(2) or 15(1) of the Act may be applied to tax benefits,in the hands of 19(1) and possibly 19(1).  It may be argued that, as 19(1) or their respective corporations concurred in respect of the transfer of property to USCo, the, amount of she benefit shall be included in computing the incomes of 19(1) as if the excessive funds had been transferred to them (subsection 56(2) of the Act).  In the alternative, it may be argued in respect of subsection 15(1) of the Act that Canco A and Canco B conferred benefits upon their shareholders, 19(1) directing P/S to pay excessive amounts to USCo.  Canco B only has a 10% interest in P/S it may be more difficult to tax 19(1) under subsection 56(2) of the Act.  Finally, (new) subsection 246(1) of the Act may be applied in respect of benefits (other than "grandfathered" benefits) conferred after September 12, 1988.

FAPI

Depending upon the particular facts, it appears that subparagraph 95(2)(b)(i) (and possibly subparagraph 95(2)(b)(ii)) of the Act may apply to 19(1) in respect of payments made by P1S to USCo (a controlled foreign affiliate) in respect of services to be provided to P1S from USCo.

Recommendation

In summary, the preferred alternative seems to be the application of (old) paragraph 245(2)(a) of the Act, supported by the FAPI rules.

We hope our comments will assist you.

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