11 March 1991 Ministerial Letter 902408 F - Residual Interest in a Partnership

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.

Dear Sirs:

Re:  Residual Interest in a Partnership

This is in reply to your letter of September 4, 1990 in which you requested us to confirm your opinion regarding the application of subsection 98.1(1) and 96(1.1) of the Income Tax Act (the "Act") in a certain hypothetical situation.

Our understanding of the hypothetical situation is as follows:

1.     A Co. is a Canadian-controlled private corporation as defined in paragraph 125(7)(b) of the Act, and is a partner in a partnership.

2.     The principal activity of the partnership is that of carrying on an active business which is carried on primarily in Canada.  Active business has the meaning assigned by paragraph 125(7)(a) of the Act.

3.     A Co. withdraws from the partnership, ceasing to be a partner and ending its association with the business activity of the partnership.  Notwithstanding the withdrawal of A Co., the partnership will continue to exist and will be carried on by the remaining partners.

4.     Prior to the withdrawal of A Co., the capital account (both for income tax purposes and for financial reporting purposes) of A Co. is $1 million.

5.     In satisfaction of A Co.'s interest in the partnership, the partnership agrees to pay out the $1 million capital account to A Co. over a period of time and to pay interest to A Co. at normal commercial rates on the unpaid balance due to A Co.

6.     A Co. will secure its unpaid amount against assets of the partnership.

7.     After A Co. withdraws from the partnership, there will be no allocation to A Co. of any share of the partnership's income or loss.

Your View

A Co., as a retired partner, has, pursuant to subsection 98.1(1) of the Act, a residual interest in the partnership by virtue of its $1 million capital account which the partnership has agreed to pay to it following A Co.'s retirement.  A Co. will retain this residual interest until such time as the full amount of its capital account has been paid out by the partnership.  The amount of interest paid by the partnership as described in paragraph 5 above will be considered to be "interest" for all purposes of the Act and thus:

(a)     will be deductible to the partnership under paragraph 20(1)(c) of the Act;

(b)     will be considered to be Canadian investment income, as defined by subsection 129(4) of the Act, in the hands of A Co. and not an allocation of a share of income or loss of the partnership; and

(c)     to the extent that the payment of such interest becomes doubtful, A Co. will be eligible to claim a reserve for doubtful debts under paragraph 20(1)(1) of the Act.

Our Response

Since a partnership is the relationship that subsists between persons carrying on business with a view to profit, and is not in itself an entity, it is generally true that an "expense" paid to a partner is nothing more than an allocation of income of the partnership.  However, the relationship among a retiring partner and the other partners ceases when the partner withdraws from the partnership, although a retiring partner-may be allocated a portion of the partnership income for a period following his retirement.  Where there is an agreement for a retiring partner to receive payments from the partnership following his retirement, it is the terms of the agreement which will determine whether subsection 96(1.1) or 98.1(1) applies.  In general terms, subsection 98.1(1) provides for the distribution of assets to a retiring partner whereas subsection 96(1.1) provides for the allocation of income earned subsequent to the partner's retirement.

In the above example, it is apparent that the agreement is one of distributing property rather than allocating income.  That being so, A Co. has, pursuant to paragraph 98.1(1)(a) of the Act, a residual interest in the partnership since A Co. has a right to receive property from the partnership in satisfaction of his interest in the partnership.  Pursuant to paragraph 98.1(1)(c), A Co. will recognize a gain on the disposition of its partnership interest only to the extent that the aggregate of amounts required by subsection 53(2) to be deducted in computing the adjusted cost base ("ACB") of its partnership interest exceeds the aggregate of amounts required by subsection 53 (1) to be added in computing that ACB.  Although A Co. is deemed not to have disposed of its partnership interest, A Co. is deemed by paragraph 98.1(1)(d), for all purposes except for subsection 85(3), not to be a member of the partnership and thus the payment of a reasonable amount of interest could not, in the absence of a subsection 96(1.1) agreement, be  viewed as an allocation of partnership income.  Since the payment of interest is not in satisfaction of A Co.'s share of partnership capital or income, the amount of interest paid would not be a payment described  in subparagraph 53(2)(c)(v) and thus would not affect the calculation of the gain or loss on the disposition of the partnership interest.  Instead, interest would simply constitute income (investment income) in the hands of A Co.

Where A Co.'s right to receive the $1 million is satisfied in full before the end of the fiscal year of the partnership in which it retired, A Co. will be deemed by paragraph 98.1(1)(b) not to have disposed of its residual interest until the end of that fiscal period.  Otherwise, A Co. will be considered to have disposed of its right at the time the right is satisfied in full.

Based on our understanding of the hypothetical situation as commented on above, the payment of the $1 million amount will be on account of capital not income.  Since the $1 million amount is not brought into A Co.'s income, no reserve can be claimed under paragraph 20(1)(1) if the payment of this amount becomes doubtful. The $1 million in the capital account will be the net result of various additions to and reductions from that account, and these adjustments would have been taken into consideration for tax purposes by way of adjusting the ACB of A Co.'s partnership interest.  However, to the extent that A Co. reports interest income which has not been received and the payment of which becomes doubtful, A Co. will be able to claim a reserve under paragraph 20(1)(1).

Concerning the deductibility of the interest expense, it is noted that the interest is not calculated with respect to "borrowed money" and therefore would not constitute a deductible expense to the partnership.  In this hypothetical situation, because the $1 million owing is on capital account, the interest is also considered a capital payment and would only be deductible under the provisions of paragraph 20(1)(c).  However, paragraph 20(1)(c) provides for the deduction of interest if it is calculated with respect to "borrowed money" or to amounts payable for property acquired and the $1 million owing, being on capital account, is neither of these.  If, on the other hand, the partnership borrowed funds in order to pay out the $1 million to A Co., the interest may be a deductible expense but only to the extent the borrowed funds could be considered to replace funds used to earn income from the business.  Concerning A Co., such payout would be in satisfaction of his right to receive property from the partnership.

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

Yours truly,

for DirectorBusiness and General DivisionRulings DirectorateLegislative and Intergovernmental Affairs Branch