27 May 1993 Internal T.I. 9310007 F - Partnership Holding Real Estate Prop. - 20(1)(c)

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.

XXXXXXXXXX

Attention:  XXXXXXXXXX 

Chief of Audit 

XXXXXXXXXX

This is in reply to your (XXXXXXXXXX) memorandum dated March 29, 1993, with reference to your fax forwarded to our office on February 16, 1993. You are requesting a legal opinion as to whether or not the partners contributed their condominium units to the partnership as a capital contribution.

Facts:

The facts as we understand them are as follows:

XXXXXXXXXX

XXXXXXXXXX

Issues to be Addressed:

1.     The representative has asked that we address the following issues:

a)     Does the partnership agreement support and/or provide for a contribution of capital being the equity in each condominium unit? If yes, how much?

b)     Did each partner borrow to make that capital contribution referred to above?

c)     Should the partnership be permitted an interest deduction under paragraph 20(1)(c), (assuming there is a reasonable expectation of profit), if it paid the interest expense even though the partner actually borrowed the funds to purchase the unit in trust for the partnership?

Partnership Representative's Comments:

2.     XXXXXXXXXX is of the opinion that section 4 of the partnership agreement allowed the partners to contribute their condominium units to the partnership at the outset as a capital contribution. He is also of the opinion that the interest expense is deductible at the partner level and that capital cost allowance may be claimed against the net rental income from the property.

3.     As a result, XXXXXXXXXX faxed to your office a revised copy of the financial statements for the partnership for 1988, 1989 and 1990 changing the name of the "Investment in Rental Property" into "Land, Building and Furniture and Fixtures" and converting the notes and mortgages payable into "Partner's Equity". He also claimed CCA to reduce the income of the partnership to nil for those fiscal periods. Since the interest was paid by the partnership on behalf of the partners, it was charged as drawings to capital account of each partner.

4.     Based on the loan documentation, his opinion is that the loans are obligations of the individual partners themselves, not of the partnership, and, as a result, would be considered as private debts of the partnership as understood by paragraph 11 of the partnership agreement.

5.     XXXXXXXXXX is of the opinion that section 4 of the partnership agreement supports "the view that each partner capitalized his Partnership interest at the outset by contributing the Unit". From his interpretation of section 4, he is arguing that each partner capitalized the partner's interest in the partnership by contributing any realizable equity in the unit purchased by the partner. The partner borrowed the money to finance the capital contribution. Their comments are found in letters dated August 5 and December 16, 1992.

6.     The result is that each unit is held as an asset of the partnership, producing rental income reported by the partnership and the mortgage against each asset is held outside the partnership by the partners.

Your Comments:

7.     You are of the opinion that the interest expense reported on the financial statements of the partnership should remain as filed and an argument for no expectation of profit at the partnership level should be continued. Notwithstanding that position, you are also of the view that the argument at the partner level should be the same, i.e. the interest expense was not laid out to earn income.

8.     Your opinion is based on the fact that the partnership maintained the books and records with respect to the units held as assets of the partnership and with respect to the liabilities recognized as liabilities of the partnership and that very little capital contributions were made and negative capital account balances were reported. "Their entire course of conduct is consistent with that stipulated in the partnership agreement. Not one of the investors questioned the deduction of the interest by the partnership, nor did anyone attempt to claim any interest at the partner level for the three years prior to the commencement of our audit".

9.     You are also of the view that the partnership agreement was entered into prior to the purchase of any of the condominium units. You are saying that the units were purchased with each member's knowledge of the partnership agreement and its specifics. In your opinion, the units were purchased in trust for the partnership and the partners were acting as agents for the partnership. "This leaves the units as an asset of the partnership and the liability associated with that asset, an obligation of the partnership, as filed".

Our Comments:

10.     Based on a review of the partnership agreement and all other documentation in the file, we are of the opinion that the accounting treatment of the condominium units, mortgages as well as the notes payable was properly determined by the accountant when he initially prepared the financial statements. It is a general practice in common law provinces for partners to purchase real estate property as agents for the partnership.

11.     The Income Tax Act reflects this practice in paragraph 96(1)(c) where it says that "each partnership activity (including the ownership of property) were carried on by the partnership as a separate person .." It means that the ownership of property will be considered as a partnership activity for the purpose of subdivision "j" of Division B of Part I of the Act. As a result, it is common practice to add a comment such as the one in paragraph 4 of the partnership agreement to the effect that the partners were acting as trustees (normally, it refers to "agents" rather than "trustees") for the partnership when they bought the condominium units.

12.     In reply to your first question, we agree that the partnership agreement provides for a contribution of capital being the equity in each condominium unit. However, our understanding of the first sentence of paragraph 4 of the partnership agreement is that the equity that each partner contributed to the partnership was supposed to come from the sale by the partnership of real property purchased by the partnership, not from the capitalization of condominium units by each partner. The equity referred to by the representative in his submission represents the condominium unit. As you mentioned in your submission, there was no or almost no equity in each condominium unit as they were almost 100% financed. If we had to allow an amount as equity, it would be the down payment made by each partner, if any.

13.     Concerning the second question, it is our opinion that each partner borrowed money when he/she bought his/her condominium unit. However, each partner acted as an agent of the partnership when he/she borrowed the money. This is confirmed by paragraph 4 of the partnership agreement and by the way that the partnership initially recorded the mortgages and notes payable in its books and records. Furthermore, all the repayments on these loans were made by the partnership, not by the partners.

14.     In response to your third question, if the partnership has a reasonable expectation of profit (based on the facts over a period of years), it would be difficult to deny the deduction under paragraph 20(1)(c) even though the partner borrowed the funds to purchase the unit in trust for the partnership. However, on the assumption that the partnership has no reasonable expectation of profit, which appears to be the case in the instant file (three years of losses), the purpose test in paragraph 20(1)(c) would not be met and we could deny the interest deduction to the partnership under 20(1)(c).

15.     Subparagraph 20(1)(c)(ii) allows a deduction, in computing the income of a taxpayer, of an amount paid in the year or payable in respect of the year pursuant to a legal obligation to pay interest on an amount payable, for property acquired for the purpose of gaining or producing income therefrom or for the purpose of gaining or producing income from a business. In the court case of The Deputy Minister of Revenue Quèbec v. J. Lipson, 79 CTC 247, at page 250, the Supreme Court of Canada concluded that in order for an expense to be admissible as a deduction from a taxpayer's income, it must have been incurred in order to make a profit. It is not enough that the expense was incurred in order to obtain gross income, ...., to gain income means to yield a profit.

16.     In an article published in Canadian Tax Journal in 1979, volume #4, concerning the Lipson case in relationship with paragraph 20(1)(c), the author, T.E. McDonnell of McMillan, Binch, Toronto, at that time, mentioned that:

"The decision of the Supreme Court in the Lipson case would seem to suggest that in order to support a claim for an interest deduction under paragraph 20(1)(c), one will have to show income in the sense of a net return, not merely a gross return".

17.     It is our opinion that the money borrowed was not used for the purpose of earning income from a business or property for the period under review, even before a "CCA" deduction. It is our view that no income/profit was earned during the years under audit by the partnership. As a result, the interest deduction would be disallowed under paragraph 20(1)(c) of the Act. In this respect, we would advise that although the Department has allowed, in the case of preferred shares, an interest deduction to the extent of dividends earned (Question #28, 1987 Corporate Management Tax Conference), this policy is restricted to the purchase of shares and is not intended to apply in situations such as the present case.

18.     As we appear not have all the facts before us, we cannot comment definitively on the reasonable expectation of profit (hereafter "REP") test as this is a question of fact. However, if you can support that the partnership had no reasonable expectation of profit in the years under audit, you could disallow the losses claimed by each partner. Jurisprudence on REP issue varies from one case to another. In some cases, paragraph 18(1)(h) will be applied to disallow the losses as personal and living expenses. In other situations, the test of REP will be done according to paragraph 18(1)(a) and subsection 9(1). Finally, in other tax cases, REP will be determined in accordance with subsections 3(d), 9(1), 9(2) and 248(1). In analysing the kind of activity carried out by a taxpayer, the courts have concluded that the absence of REP denies the existence of a source of income. Then, since the activity is not a source of income, subsections 248(1) defining "business", 9(1) and 9(2) dealing with the calculation of income and loss from business or property, as well as paragraph 3(d), cannot apply to allow as a deduction from other income the losses sustained by the taxpayer.

19.     If the taxpayers' representatives submit additional representations on this matter, we would be pleased to provide you with our comments, if you so wish.

We trust that the above comments will be of assistance to you.

Section Chief Manufacturing Industries, Partnerships and Trusts Section Manufacturing Industries, Partnerships and Trusts DivisionRulings DirectorateLegislative and Intergovernmental Affairs Branch