17 July 1991 Administrative Letter 911476 F - Active vs. Passive Income - Partnership and Co-Own

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:

This is in reply to your letter of May 28, 1991 wherein you requested a technical interpretation of subsections 96(1) and 103(1) of the Income Tax Act (the "Act"). To illustrate, you have provided us the following hypothetical facts:

-      Partnership AB, a Canadian partnership, has two partners, A and B.

-      Partners A and B deal with each other at arm's length.

-     Pursuant to the partnership agreement partner A receives a minimum return on capital invested prior to the allocation of income or loss of partnership AB to the individual partners. The income or loss, after minimum return on capital to partner A, will be allocated between the two partners in accordance with the partnership agreement.

Your Opinion

Pursuant to subsection 96(1) of the Act, the income or loss of partnership AB will be allocated to the individual partners to the extent of their share as determined by the partnership agreement.

Income or loss of partnership AB is calculated under Division B of the Act as if the partnership were a person.

The minimum return on capital would not constitute a business expense of the partnership as it was not incurred to earn income, rather it is a method of distributing the partnership income among its members.

Paragraphs 10 and 11 of the Interpretation Bulletin IT-138R describe a similar situation in which the partnership agreement provides for an initial salary to a partner prior to allocation of income or loss between the individual partners. The view set forth in IT-138R is that the salary represents a distribution of income rather than a business expense.

As such, as set out in IT-138R, the salary is first allocated to the relevant partner and the remaining income/loss of the partnership after reduction of the salary is allocated to the partners in accordance with the partnership agreement.

Provided the end result of the allocation is reasonable and not for the reduction and postponement of tax, thereby not offending subsection 103(1) of the Act, the minimum return on capital should be treated as described in paragraphs 10 and 11 of  IT-138R.

Our Comments

In the hypothetical facts above, the source of income of partnership AB was not provided. We assume that business income was the only source of income of partnership AB.

The minimum return of capital has been considered as interest income to a partner even though there is no offsetting deduction available to a partnership. However, in our opinion, subject to the possible application of section 103 of the Act and reasonableness test on the rate of interest, a minimum return on capital can be considered as a distribution of income to the extent that it does not exceed the income of the partnership for the particular fiscal year. If both partners contributed capital to the partnership, a minimum return on capital available to one partner while not the other might be considered offensive and section 103 of the Act might apply. A review of the tax position of all partners would be necessary to determine whether there was any reduction or postponement of tax. However, it is always a determination of fact whether section 103 of the Act is applicable or whether the rate of interest is reasonable.

These comments represent our opinion of the law as it applies generally. As indicated in paragraph 21 of the Information Circular IC70-6R2, this opinion is not a ruling and accordingly, it is not binding on Revenue Canada, Taxation.

Yours truly,

for DirectorBusiness and General DivisionRulings DirectorateLegislative and Intergovernmental     Affairs Branch