Can Advances to Limited Partners Give Rise to Negative-ACB Gains?

The CRA stated in a recent TI (2016-0637341E5, June 27, 2016) that a loan of current-year cash flow received by a limited partner from a Quebec limited partnership may be treated as an amount received "in lieu of" a distribution of the partner's share of the partnership's profits for the purposes of the ACB reduction rule in subparagraph 53(2)(c)(v), even if the loan is legally valid under Quebec partnership law and is not a sham. This position calls into question the effectiveness of a commonly used planning technique whereby a limited partnership advances rather than distributes its profits to its members during its fiscal year in order to avoid triggering a negative-ACB gain under subsection 40(3.1).

There is a well-known timing mismatch between additions to the ACB of partnership interests in respect of partnership income allocable to such interests and deductions from the ACB of partnership interests in respect of distributions on such interests. Subparagraph 53(1)(e)(i) requires that a partner's share of partnership income for a particular fiscal year be added to the ACB of its partnership interest after the partnership's fiscal year-end. By contrast, subparagraph 53(2)(c)(v) requires that any amount received by the partner "as, on account or in lieu of payment of, or in satisfaction of" a distribution of the partner's share of the partnership profits be deducted from the ACB of its partnership interest at the time of receipt.

If a limited partner's share of the partnership's profits exceeds the ACB of its partnership interest, a distribution of its share of the profits before the fiscal year-end will generally result in a negative ACB of the interest and, accordingly, a deemed capital gain under subsection 40(3.1). A planning technique that is often used to avoid this result is to cause the partnership to advance funds to the limited partner during the fiscal year and then declare a distribution of the partner's share of the profits after the fiscal year-end. A promissory note is then issued and set off against the advances made to the limited partner in the previous fiscal year. These steps can be repeated year after year in order to give the limited partner the benefit of the use of the partnership's current-year cash flow.

In the TI, the CRA asserted that even if the loans are legally valid and are not a sham and the legal forms of the loan and subsequent distribution are respected, subparagraph 53(2)(c)(v) could theoretically apply to loans of current-year cash flow, given the breadth of the expression "in lieu of." However, the CRA's position appears unjustified. Subparagraph 53(2)(c)(v) requires that the cash be received "in lieu of payment of" a distribution of partnership profits. This wording suggests that the amount that is received "in lieu of payment of" a distribution of partnership profits must be a substitute for, and replace, the payment of the distribution of partnership profits. Because a loan of current-year cash flow is typically followed by a distribution of partnership profits after the end of the fiscal year, one cannot reasonably argue that the loan is a substitute for, and replaces, the payment of a partnership distribution.

This reading is consistent with the case law cited by the CRA in the TI in support of the broad scope of the expression "in lieu of." In Transocean Offshore Ltd. (2005 FCA 104), amounts paid in respect of the anticipatory breach of a rental agreement were found to be "in lieu of" the payment of rent under the agreement. In Holzhey (2007 TCC 247), the taxpayer's deemed disposition of a loan on which there was accrued and unpaid interest was considered to result in the taxpayer's deemed receipt of an amount in lieu of the payment of interest. Similarly, in Hall (70 DTC 6333 (Ex. Ct.), aff'd. 71 DTC 5217 (SCC)), the taxpayer who sold matured interest coupons was found to have received the sale proceeds in lieu of the payment of interest.

On the CRA's interpretation of subparagraph 53(2)(c)(v), there might be two ACB reductions in respect of the same partnership profits—once on a current-year loan of the profits to the limited partner and again on the actual distribution of the profits after the fiscal year-end—clearly an absurd result. Thus, it appears that the scope of subparagraph 53(2)(c)(v) is narrower than the CRA contends.

Kabir Jamal
Goodmans LLP, Toronto
kjamal@goodmans.ca

Canadian Tax Focus
Volume 7, Number 1, February 2017
©2017, Canadian Tax Foundation