Substantive attributes of a partnership (p. 20:6)
[T]he court’s reasoning in Memec supports an approach to entity classification for tax purposes that determines the essential attributes of an arrangement by reference to the substantive rights and obligations of the parties, and not merely by the existence, or lack thereof, of separate legal personality. …
The members of a partnership, owing to its contractual nature, (1) have a proprietary interest in property held in partnership (although they have no direct ownership interest in such property), (2) are agents for each other (with the ability to legally bind each other), and (3) generally have unlimited liability for the liabilities of the partnership, unless registration is made to provide for limited liability. [fn 25: C.L. Dreyfus … (1929), 14 TC 560 (CA).]
Quaere whether beneficiary is beneficial owner (pp. 20:7-8)
Some commentators argue that a beneficiary of a trust is the beneficial owner of trust property, while others consider a beneficiary to have only a personal right to compel the trustee to administer a trust pursuant to the terms of the trust agreement. [fn 30: … (2003) Canadian Tax Journal 311-54 … 401-53]
[T]here will be a bare trust where the trustee—in all dealings relating to the trust property—has no discretion and is subject to the control of another person. [fn 36: See Peragine v. The Queen, 2012 TCC 348, at paragraph 18, where the court quotes De Mond Jr. v. The Queen, 1999 CanLII 466 (TCC), at paragraphs 37-38]
Quaere whether beneficiary is beneficial owner (pp. 20:7-8)
Some commentators argue that a beneficiary of a trust is the beneficial owner of trust property, while others consider a beneficiary to have only a personal right to compel the trustee to administer a trust pursuant to the terms of the trust agreement. [fn 30: … (2003) Canadian Tax Journal 311-54 … 401-53]
[T]here will be a bare trust where the trustee—in all dealings relating to the trust property—has no discretion and is subject to the control of another person. [fn 36: See Peragine v. The Queen, 2012 TCC 348, at paragraph 18, where the court quotes De Mond Jr. v. The Queen, 1999 CanLII 466 (TCC), at paragraphs 37-38]
Beneficial owner equates to the real owner of property (p. 20:90)
Although the term “beneficial ownership” is not defined in the Act and its meaning has been the subject of much debate, it has been considered, in the jurisprudence, to mean the “real owner of the property” possessing the right to enjoy, and assuming the risk of loss in respect of, the property. [fn 235: 568864 B.C. Ltd. v. The Queen, 2014 TCC 373; Covert et al. v. Minister of Finance of Nova Scotia, [1980] 2 S.C.R. 774; MNR v. Wardean Drilling Ltd., 69 DTC 5194 (Ex. Ct.); Hewlett Packard (Canada) Ltd. v. Canada, 2004 FCA 240, and Canada v. Morin, 2006 FCA 25. See also Canada v. Prévost Car Inc., 2009 FCA 57; and Velcro Canada Inc. v. The Queen, 2012 TCC 57 for the judicial consideration of the meaning of “beneficial owner” in the context of tax treaties.]
LLCs can generate exempt earnings (pp. 20:10-11)
[T]he fundamental requirement—established in paragraph (d) of the “exempt earnings” definition in regulation 5907(1)—is that the FA be resident in a designated treaty country (DTC)….
[I]n the case of a treaty country, DTC residence for surplus purposes will exist only where the FA is resident in the country for both common-law and tax treaty purposes.
[F]iscally transparent entities, such as LLCs, are generally not considered treaty residents. However, such entities are accommodated by the residence rules applicable for FA surplus purposes. Under regulation 5907(11.2)(b), an FA will qualify as a treaty resident of a country if it would be resident in that country if treated as a body corporate for the purpose of income taxation in that country. An LLC, if it were treated as a body corporate for US income tax purposes, would be a resident in the United States under the Canada-US treaty. Thus, an LLC may qualify as a DTC resident for FA surplus purposes provided that it is resident in the United States under common-law principles.
Most pro rata corporate distributions are dividends (pp. 20:16-17)
Cangro Resources … held that for the purposes of the Act, “dividend” was to be given its “accepted ordinary meaning” – that is, of a pro rata distribution to all shareholders, other than a formal reduction of paid-up capital or liquidating distribution. …
Despite the CRA’s administrative practice, the essence of a dividend, according to the jurisprudence, is a pro rata distribution by a corporation among its shareholders that is not a reduction of capital or a liquidating distribution. The source within the corporation from which the distribution is made is irrelevant.
Potential net taxable income inclusion as a result of pro rata FMV rule (p. 20:37)
[I]f the proportionate FMV of a member’s partnership interest is less than the member’s share of partnership income (on the basis of the allocation provided in the partnership agreement and included in the member’s income pursuant to paragraph 12(1)(l) and subsection 96(1)), the section 113 deductible amount is not sufficient to fully offset the income inclusion. This is because the dividend deemed received by the member pursuant to paragraph 93.1(2)(a), on which the section 113 deduction depends, is based on the proportionate FMV of the member’s partnership interest and not on the amount of the dividend actually allocated to the member pursuant to subsection 96(1).
S. 93.1(2)(d)(i) applies to gross amount of dividend
It seems to be a well-established and accepted position that the limitation is meant to apply to the gross amount of the dividend that is taken into account in computing the partnership’s income, without reference to interest or any other expense or deduction taken by the partnership to compute its net income. This position is consistent with the legislative history of the provision and with the CRA’s administrative approach.
QROC election intended to address unavailability of Reg. 5901(2)(b)(ii) election to partnerships
[A]lthough subsections 93.1(1) and (2) are meant to allow a CRIC to access this [FA dividend] regime through partnerships, no pre-acquisition surplus election is available to a partnership that is a shareholder of the distributing FA, even if each of its members is a CRIC or an FA of a CRIC….
[W]hile available to all taxpayers, the QROC election is really for the benefit of partnerships and of other taxpayers that are ineligible for the pre-acquisition surplus election….
Unavailability of s. 93 regime where partnership interest disposed of (p. 20:49)
[S]ubsection 93(1.3) applies only where the shares disposed of are EP. This appears to be an oversight; prior to the 2013 amendments, the mandatory provisions generally applied only (in the non-partnership and partnership contexts) in respect of EP shares. The 2013 amendments eliminated this requirement in the non-partnership context, but it remains in subsection 93(1.3)….
[T]he section 93 regime does not apply to any gain realized by a CRIC, or an FA of a CRIC, in respect of a disposition of a partnership interest in a partnership that holds FA shares. In such a case, the benefits offered by the section 93 election dividend election are not available, and an actual dividend must be paid in order for a CRIC to benefit from any underlying FA surplus (which may have foreign withholding tax consequences … ). On the other hand, the loss denial rules in section 93 … do apply where a partnership interest is sold. The reason for this apparently inequitable treatment is not clear.
Narrowness of the postamble to the excluded property (EP) definition (p. 20:53)
[A]lthough the partnership postamble applies for the purposes of the FA definition as it does for the purposes of the EP definition, it must be recalled that it deems only shares of the deemed non-resident corporation to be owned by a member of the partnership that is an FA of any taxpayer. No other person—including the CRIC itself or a CRIC related to the taxpayer —is deemed to own shares of the deemed non-resident corporation, [fn 163: The CRA has confirmed this interpretation ... 2014-0546581E5 ...] and, without ownership, the “direct equity percentage” definition in subsection 95(4) cannot apply. There does not appear to be a policy reason for the more narrow application, with the result that the implications are incongruous when compared with a scenario in which the partnership is instead a corporation.
This can give rise to unexpected EP issues in split-ownership scenarios.
Potential qualification of partnership interest under EP – para. (a) if (e) unavailable (p. 20:55)
- CRIC 1 owns 50 percent of the shares of an FA (FA 1);
- FA 1 has a 10 percent interest (by FMV) in a partnership that carries on an active business for the purposes of the FA regime;
- CRIC 2 has a 5 percent interest (by FMV) in the partnership.
FA 1 is disposing of its partnership interest. However, this interest is not EP under paragraph (b), since CRIC 1’s equity percentage in the deemed non-resident corporation is only 5 percent for the purposes of the EP definition. Under the partnership postamble (as noted above), only FA 1 is deemed to own shares of the deemed non-resident corporation. Consequently, the partnership would not be considered an FA of CRIC 1 and FA 1’s interest in the partnership does not qualify as EP.
However, in this scenario, there are good arguments to be made that paragraph (a) of the EP definition should apply to FA 1’s partnership interest, without recourse to paragraph (b) and the deemed non-resident corporation status that arises under the partnership postamble. A partnership interest may qualify as EP under paragraph (a) when the partnership carries on an active business, on the basis that the partnership interest is property held by FA 1 principally for the purpose of gaining or producing income from an active business carried on by FA 1. [fn 165: In…7-2672…the CRA stated that, “in our view a good argument can be made that a partnership interest that does not otherwise qualify as excluded property, say because of the 10 percent limitation, could qualify as excluded property under subparagraph (i).” Subparagraph (i) is now paragraph (a) of the EP definition.] Under partnership law in common-law provinces, all members of a partnership are considered to be carrying on any activity carried on by the partnership [fn 166: Robinson Trust …98 DTC 6065… nos. 9722815…2000-0059145,…2001-0090655;…2002-0149977,…and 2001-0070605,…See also 9636835…confirmed…2012-0453991C6(f)…after this principle was challenged in the case of Quebec civil-law partnerships in Laval (Ville de) c. Polyclinique médicale Fabreville, s.e.c., 2007 QCCA 426; and Ferme CGR enr., s.e.n.c. (Syndic de), 2010 QCCS 2; aff’d 2010 QCCA 719] (including limited partners that do not take part in the management of the business).]
Initial concern re s. 95(1) – EP – para. (c) that property of the partnership could not qualify (pp. 20:56-59)
When the EP definition was first proposed in 1982, the draft provision raised concerns that property of the partnership could not qualify as property of the FA. … The tax community expressed a concern that where an FA has an interest in a partnership that carries on an active business, the partnership interest of the FA could qualify as EP, but partnership property used for the purpose of gaining or producing income from an active business could not so qualify … [so] that where a partnership of which a foreign affiliate is a member disposes of capital property used principally for the purpose of gaining or producing income from an active business, the property does not qualify as excluded property … .
… Although the current definition continues to refer to property “of the” FA, it has been accepted that the partnership postamble resolves the concern that arises where partnership property has been disposed of. The CRA’s approach seems to be that if the gain realized by a partnership from the disposition of property would be EP if the partnership qualified as another FA of the taxpayer (on the basis that the partnership is deemed to be a non-resident corporation and the FA member has the requisite interest in the partnership), the gain’s character as a gain from the disposition of EP is retained when it is allocated to the FA member.
[U]nlike other provisions, the EP definition does not expressly require “ownership” of particular shares. It requires only that property be “of the” FA. Pursuant to Canadian common-law partnership principles, each member is considered to have an undivided interest in the property of the partnership.
S. 95(2)(y) does not preclude FA also being FA of partnership (p. 20:61)
The CRA has confirmed that the attribution of share ownership from the partnership to its members for FA and QIFA purposes does not prevent the partnership sub from also being an FA and QIFA [FA with a qualifying interest] of the partnership, where the partnership is the relevant taxpayer. [fn 182: … 2011-0415911E5 … .]
Example of curative effect of s. 95(2)(z) (pp. 20:63-64)
In this example, Inactive FA earns interest income from Active FA. The recharacterization rule applies to each relevant taxpayer (the CRIC and the partnership) in respect of Inactive FA. When the recharacterization rules are applied to Inactive FA’s income vis-à-vis the CRIC as taxpayer,
- each of Inactive FA and Active FA is a QIFA of the CRIC; and
- subparagraph 95(2)(a)(ii) applies to recharacterize Inactive FA’s income as income from an active business.
When the rules are applied to the partnership as the taxpayer,
- Inactive FA is a CFA and a QIFA of the partnership;
- Active FA is not a QIFA of the partnership;
- subsection 93.1(5) does not apply because, when the relevant assumptions are applied, CRIC and the partnership are not related.
Thus, Inactive FA’s income from property is FAPI in respect of the partnership and is included in its income, under subsection 91(1), as income from property. Absent paragraph 95(2)(z), 49 percent of this amount would be attributed to FA 1 and included in its FAPI in respect of the CRIC. If FA 1 held its interest in Inactive FA directly, there would be no FAPI in this scenario.
Paragraph 95(2)(z) is intended to prevent this result. Paragraph 95(2)(z) applies where
- a particular QIFA (FA 1) of a taxpayer (the CRIC) is a member of a partnership;
- the partnership has income that is attributable to the FAPI of an FA of the partnership (Inactive FA) that is also a QIFA or CFA of the taxpayer (the CRIC); and
- the income of Inactive FA is included in its active business income because of the application of paragraph 95(2)(a) in respect of the taxpayer (the CRIC).
Because all of these conditions are satisfied in the example above, paragraph 95(2)(z) applies to exclude, in the computation of FA 1’s FAPI in respect of the CRIC, FA 1’s share of the partnership’s income that is attributable to Inactive FA’s FAPI in respect of the partnership.
Dubious textual interpretation of s. 95(2)(a)(ii)(B)(II) (“Cap B”) in 2016-0680801I7 (pp. 20:65-69)
The CRA recently considered the application of Cap B in recharacterizing interest income earned by an inactive FA that has made a loan to a partnership that was not wholly owned by the CRIC’s group. [fn 187: 2016-0680801I7.]
The CRA’s approach to the second part of what it considers to be the “separate tests” that must be met for Cap B to apply appears incorrect from a textual perspective. Cap B does not require that the amounts paid for “expenditures” (that are deductible by the partnership) be included in computing the prescribed earnings of the FA member of the partnership. Rather, it requires that the FA member’s “share of any income or loss of the partnership” be included in computing such earnings. This interpretation accords with the grammar of the provision; specifically, the words “that is” reference the singular “share of any income or loss” and not the plural “expenditures.”…
Narrow scope of s. 93.1(4)(b)/same country residence requirement (pp. 20:75-76)
[I]t appears that the only function of paragraph 93.1(4)(b) is to allow a determination of whether the inactive FA’s interest income—once deemed active by clause 95(2)(a)(ii)(D)—is included in the inactive FA’s exempt earnings or its taxable earnings. This conclusion is supported by the explanatory notes accompanying the provision’s introduction, which show evidence of an intention to permit “exempt earnings” treatment for income that has been recharacterized as active business income.
Clause (2)(d)(E) of the “exempt earnings” definition … applies to income that is recharacterized as active business income under clause 95(2)(a)(ii)(D). Subclause (2)(d)(E)(I) requires that each of the second and third FAs be resident in a DTC. Thus, interest that is paid by a partnership that is the “second affiliate” may be included in the exempt earnings of the recipient, provided that the partnership and the third affiliate are each resident in a DTC (and the EP requirements are fulfilled). The residence of the partnership is established in accordance with paragraph 93.1(4)(b).
This residence requirement is tricky. First, each member of the partnership must be resident in the same country. Second, the partnership must carry on its business only in that same country. In foreign partnership structures, it is not unusual to see partners in different jurisdictions….
S. 95(2)(y) may be broad enough to render s. 95(2)(a)(ii)(D) applicable where FA2 borrows from sister FA Finco to fund FA Opco “through” Holdco partnership (pp. 20:76-78)
In this example, FA 2 borrows from Inactive FA to invest in the partnership, which in turn uses the funds to acquire shares of FA Opco that are EP of the partnership (or that would be EP of the partnership if the partnership were an FA of the CRIC [corporation resident in Canada]). No provision obviously applies to recharacterize Inactive FA’s income. FA 2 does not use the borrowed money for the purpose of earning income from an active business; any dividends generated on the FA Opco shares may not be FAPI, but they are not included in active business income.
In certain circumstances, it may be possible to argue that clause 95(2)(a)(ii)(D) should apply to Inactive FA’s interest income on the basis that the purpose of FA 2’s borrowing is to earn income from property—that is, the shares of FA Opco acquired by the partnership. This conclusion requires, first, that FA Opco (the “third affiliate”) be a QIFA [ [FA for which a qualifying interest] ]of the taxpayer (the CRIC). Subsection 93.1(1) does not apply for this purpose. However, as noted above, paragraph 95(2)(y) applies “in determining—for the purpose of paragraph 95(2)](a) and for the purpose of applying subsections 95(2.2) and (2.21) for the purpose of applying that paragraph”—whether a non-resident corporation is, at any time, an FA and a QIFA of a taxpayer. Under paragraph 95(2)(y), where shares of a corporation are property of a partnership, the shares are deemed to be owned at that time by each member of the partnership on a proportionate basis with respect to FMV.
It is clear, then, that FA Opco is deemed to be an FA and a QIFA of the CRIC for the purposes of clause 95(2)(a)(ii)(D). It should also be possible to conclude that the purpose of the borrowing by FA 2 is to earn income from property, in the form of income from the shares of FA Opco earned by FA 2 through the partnership. The sticking point in the analysis may be whether paragraph 95(2)(y) is broad enough to deem FA 2 to own its proportionate share of the FA Opco shares for the purpose of satisfying the requirement, set out in subclause 95(2)(a)(ii)(D)(III), that the FA Opco shares be “excluded property of” FA 2. In the context of the recent amendments that are clearly aimed at ensuring that the FA regime in general, and paragraph 95(2)(a) in particular, applies appropriately to FA structures involving partnerships, there are excellent arguments that paragraph 95(2)(y) is broad enough to accommodate this structure, on the appropriate facts. ...
Difficult application of (h) exception to security trust (pp. 20:90-92)
The following is an example of a transfer of property by an FA to an NRT, which illustrates both (1) the analysis that should apply to determine whether the arrangement constitutes a trust, and (2) if it does apply, the difficulty in satisfying the consideration requirement of a paragraph (h) EFT.
- A CRIC owns all of the shares of CFA 1, and CFA 1 holds all of the shares of CFA 2.
- CFA 2 carries on an active business in a DTC.
- The CRIC subscribes for shares of CFA 1, and CFA 1 makes an interest-bearing loan to CFA 2 (“the internal loan”).
- CFA 2 also borrows (“the CFA 2 loan”) from a local lending syndicate (“the lenders”). The terms of the CFA 2 loan require CFA 1, as the borrower’s shareholder, to provide collateral. In particular, the lenders require CFA 1 to execute an agreement creating an irrevocable trust (“the collateral trust”), with a local financial institution as trustee, and to transfer the internal loan to the collateral trust for the sole benefit of the collateral agent of the lenders.
- The sole purpose of the collateral trust is to provide the lenders with security. Its duration is linked to the term of the CFA 2 loan. The collateral trust terminates on the settlement of the CFA 2 loan.
- Subject to an event of default under CFA 2 loan, CFA 1 has the right to manage the internal loan held by the collateral trust, and to direct the trustee with respect to the investment of income or proceeds from the internal loan. Interest received on the internal loan (or income from the investment of such interest) may be distributed to CFA 1 at the request of CFA 1, subject to the consent of the collateral agent. The trustee has no independent powers or responsibilities. No capital distributions may be made from the collateral trust prior to its termination unless there is an event of default under the CFA 2 loan, in which case the trustee is required to distribute all of the property to the collateral agent, who is required to transfer to CFA 1 any property in excess of what is required to make the lenders whole.
- On the termination of the collateral trust, all of the trust property is distributed to the only named beneficiary (the collateral agent), who is obligated to transfer it to CFA 1 for no consideration. CFA 1 (as settlor) and the collateral agent (as beneficiary) can jointly agree to terminate the collateral trust at any time. ...
[S]ome provisions in the Act assume that similar arrangements, made for the sole benefit of creditors, constitute trusts under law, [fn :232 For instance, regulation 4800.] which suggests that this arrangement creates a trust at law.
Assuming that this arrangement constitutes a trust under common-law principles, it is not clear whether the collateral trust qualifies for the bare trust exception in subsection 104(1)…. If CFA 1 is considered to be a beneficiary, it is not clear that the bare trust exception applies where the trustee receives separate instructions from CFA 1 and the collateral agent, or where instructions from CFA 1 are subject to the approval of the collateral agent….
It is unclear whether the collateral trust qualifies as a paragraph (h) EFT. The fixed-interest requirement should be satisfied, because the trustee has no discretion. However, the consideration requirement may be problematic. The collateral agent’s interest may not be considered to be issued by the collateral trust in exchange for consideration that was not less than 90 percent of the interest’s proportionate share of the net asset value of the collateral trust’s property at the time of its issuance, nor acquired in exchange for consideration equal to the FMV of the interest at the time of its acquisition.
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