Partnership Withdrawal Creates a Paragraph 12(1)(l.1) Anomaly

The CRA has confirmed (in TI 2015-0567811E5, July 28, 2015) that partners that withdraw from a partnership before the partnership’s fiscal year-end may have a paragraph 12(1)(l.1) income inclusion, even if none of the partnership’s income for the fiscal year is allocated to them. This anomalous result can occur when a corporation or trust withdraws before fiscal year-end from a partnership that has outstanding debts to specified non-residents. Timing the withdrawal to coincide with the fiscal year-end can avoid this problem.

The thin cap rules generally are intended to preserve the integrity of the Canadian income tax base by denying the deduction of interest on a corporation’s or trust’s outstanding debts to specified non-residents to the extent that such debts exceed the corporation’s or trust’s permitted debt-to-equity ratio. However, because this denial rule does not apply to interest that is deductible by a partnership in computing income allocable to the partners under subsection 96(1), paragraph 12(1)(l.1) creates an income inclusion to partially offset the interest deduction.

Paragraph 12(1)(l.1) essentially requires a corporation or trust that is a member of the partnership to include in computing its income for a taxation year the amount of interest that is (1) deductible by the partnership and (2) paid or payable by the partnership in that year on certain debts. The debts in question are the partner’s proportionate share of the partnership’s outstanding debts to specified non-residents of the partner, to the extent that the amount of these debts exceeds that allowed by the partner’s permitted debt-to-equity ratio. Pursuant to subsection 18(7), each partner’s proportionate share of a partnership’s debts is deemed in most cases to equal its “specified proportion” of such debts for the last fiscal period of the partnership ending at or before the relevant taxation year of the partner and at a time when the partner was a member of the partnership.

In the specific circumstances considered in the TI, the CRA concluded that if two Cancos sold all of the interests in a partnership before the partnership’s fiscal year-end to affiliated non-resident corporations, interest paid or payable by a partnership in the fiscal year would be considered deductible by the partnership for the purposes of the paragraph 12(1)(l.1) income inclusion. This result holds even though (1) under the governing partnership agreement, all of the partnership’s income for the fiscal year would be allocated only to persons who were members of the partnership at the fiscal year-end, and (2) the non-resident affiliates to which the income would be allocated were not subject to part I tax. Although paragraph 96(1.01)(a) does not specifically provide that it applies for the purposes of paragraph 12(1)(l.1), the CRA reasoned (presumably on the basis of the FCA’s reasoning in Canada v. Olsen, 2002 FCA 3) that the paragraph would deem each Canco to be a member of the partnership at the fiscal year-end for the purposes of determining that the relevant interest expense was deductible by the partnership for the purposes of paragraph 12(1)(l.1).

The CRA also noted that because each Canco was not in fact a member of the partnership at fiscal year-end, its “specified proportion” of the partnership’s outstanding debts to specified non-residents must be computed with reference to its proportionate share of the partnership’s total income or loss for the preceding fiscal year. In the circumstances, this meant that each Canco would have a paragraph 12(1)(l.1) income inclusion even though it did not derive a corresponding benefit from the interest deductions claimed by the partnership.

This anomalous result is not restricted to the specific situation described in the TI; it can occur whenever the withdrawing partner’s proportionate share of the partnership’s income for the preceding fiscal year exceeds its proportionate share of such income for the fiscal year of withdrawal. If these two proportions do not match, the partner may suffer an inordinate income inclusion under paragraph 12(1)(l.1).

Kabir Jamal
Goodmans LLP, Toronto
kjamal@goodmans.ca

Canadian Tax Focus
Volume 5, Number 4, November 2015
©2015, Canadian Tax Foundation