16 June 1989 Income Tax Severed Letter AC57883 - Limited Partner At-risk Amount

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.

19(1)                                          5-7883
                                               C.R. Bowen
                                               (613)-957-2096

Dear Sirs:

Re: Paragraph 96(2.2)(c) of the Income Tax Act (the act)

We are writing in reply to your letter of April 6, 1989 wherein you requested our opinion on the application of paragraph 96(2.2)(c) of the Act to the at-risk amount of a limited partner in the following hypothetical situation.

Facts

Our understanding of the facts or the hypothetical situation is as follows:

A real estate developer and promoter (the developer) in the business of developing commercial and residential real estate and syndicating these developments to public investors establishes a limted partnership in order to finance the development of a particular real estate project. The general partner of the limited partnership is a wholly owned subsidiary corporation of the developer and the initial limited partner is also a related entity. After the public syndication of the partnership units, the limited partners can replace the general partner by means of a special resolution.

The limited partners may acquire the partnership units by either 1) paying the full purchase price in cash, or 2) paying cash for a part of the purchase price and signing a full recourse promissory not die to the limited partnership for the balance. The limited partnership, pursuant to its agreement with the developer, would then assign the cash proceeds and the promissory notes to the developer as payment in full for the property and the service provided by the developer to the partnership. At this point, the limited partnership would have no further interest in the promissory notes as they would be the property of the developer.

The developer would use the promissory notes as security for the loan obtained form a financial institution used to finance the completion of its obligations to the limited partnership. When the loan with the financial institution comes due, the developer must collect the amount owing to it by the limited partners. The developer will enforce the collection of this amount from the limited partners either by collecting the cash from the partner, rescheduling the debt or assuming title to the partnership unit provided as collateral and suing the limited partner for any deficiency.

It is your opinion that an equitable result will occur if the limited partner's at-risk amount must be reduced by the amount of the full recourse promissory note assigned to the developer with whom the limited partner deals at arms's length, but the general partner does not.

Our Comments

While we are unable to provide confirmation of the income tax effects of the hypothetical situation outlined in your letter, we can offer the following general comments related to the application of paragraph 96(2.2)(c) of the Act.

Where a limited partnership assigns or transfers its ownership of full recourse promissory notes received form its limited partners in payment for their purchase of the partnership units to another person (e.g. a developer) and the partnership has no further interest in the notes, the notes will generally be considered to be an amount owing by the limited partners to the developer. Although the limited partners will no longer owe an amount to the partnership, in order that this debt to fall outside of the ambit of para;graph 96(2.2)(c) of the Act, the promissory notes must not be owed to the partners to a person withe whom the partnership does not deal at arm's length. In order to determine the nature of the relationship between the developer and the partnership, it is necessary to examine the relationship between the developer and general partner, and between the partner and partnership.

Where the general partner is a wholly owned subsidiary corporationof the developer, subparagraph 251(2)(b)(i) of the Act provides that these two corporations are persons related to each other. As a result they are deemed not to deal at arm's length (by virtue of paragraph 251(1)(a) of the Act), regardless of the actual conduct of or intent of the two corporations.

It is a question of fact as to whether the general partner deals at arm's length with the limited partnership (per paragraph 251(1)(b) of the outline criteria used by the courts in making this determination. In particular, tow relevant court cases dealing with the subject of whether parties are dealing at arm's length are MNR v. Merritt Estate, 69 DTC 5159 (Ex.Ct.) and Special Risks Holdings Inc. v. The Queen 86 DTC 6035 (FCA).

In Merritt Estates, the court held that the parties were not dealing at arm's length for the purposes of the Estate Tax act. At pages 5165-5166, Mr. Justice Cattacnach summarized the relevant principles as follows:

In my view the basic premise on which this analysis is based is that, where the "mind" by which the bargaining is directed on behalf of one party to a contract is the same "mind" that directs the bargaining on behalf of the other party, it cannot be said that the parties are dealing at arm's length. In other words, where the evidence reveals that the same person was "dictating" the "terms of the bargain" on behalf of both parties, it cannot be said that the parties were dealing at arm's length.

In Special Risks, the Federal Court of Appeal approached the issue in terms of the relationship between the parties. At pages 6037-6038, Mr. Justice Pratte stated:

Paragraph 251(1)(b) of the Act provides that "it is a question of fact whether persons not related to each other were at a particular time dealing with each other at arm's length". Two persons are not dealing at arm's length when there exists between them a relationship that enables one of them to dictate the terms of a bargain to the other. That argument is based on the English version of a subsections 186(2) and 251(1); however, it cannot be reconciled with the French version of those provisions where the expression to "deal at arm's length" is translated by "avoir, un lien de dépendance". The French version makes clear, in my view, that what Parliament had in mind in referring to persons dealing or not dealing at arm's length was not persons who were actually dealing with each other but, rather, persons between whom existed a relationship of subordination.

It is our opinion that in a limited partnership with only onegeneral partner, that general partner will generally have control of the partnership's business. Therefore, as supported by virtue of the "common mind" test as outlined in Merritt Estates or the concept of " a relationship of subordination" discussed in Special Risks, it is our opinion that a sole general partner of the limited partnership would not normally deal at arm's length with that limited partnership.

In determining whether a limited partnership deal at arm's length with the developer, the fact that a transaction between unrelated persons takes place at fair market value and is consistent with arm's length dealing does not necessarily indicate an arm's length situation. This position is indicated in paragraph 14 of Interpretation Bulletin IT419 and supported by the court case Swiss Bank Corporation and Swiss Credit Bank v. MNR, 72 DTC 6470 (SCC). Although the question as to whether the developer deals at arm's length with the partnership will be dependant on the facts of a particular situation, it is our opinion that generally a developer will not deal at arm's length with the partnership where a non-arm's length relationship exists between the developer and the general partner and between the general partner and the partnership. In this type of arrangement, the developer generally should have de facto control over the limited partnership and would exercise a common mind in directing the transactions of the limted partnership. As well, a relationship of subordination would exist between those two parties. Consequently, it is our opinion that the at-risk amount of a limited partner will be generally reduced by the amount of the promissory note owing by it to the developer in the situation described above.

These comments represent our opinion of the law as it applies generally. As indicated in paragraph 24 of Information Circular 70-6R dated December 18, 1978, this opinion is not a ruling and accordingly, is not binding on the Revenue Canada, Taxation.

Yours Truly,

for Director Small Business and General Division Specialty Rulings Directorate Legislative and Intergovernmental Affairs Branch