A Taxpayer Win on At-Risk Rules

In Canada v. Green (2017 FCA 107), the FCA reaffirmed an earlier TCC decision (2016 TCC 10) that a limited partnership loss (LPL) should not be "trapped" in a lower-tier limited partnership, and thus disappear, as a result of the at-risk rules in a multi-tier partnership structure. This decision overturns a longstanding CRA position (see, for example, 2004-0062801E5, May 14, 2004). It appears to allow the avoidance of the at-risk rules by interposing a general partnership immediately below the top-tier partner; but, as the court mentioned in relation to this possible strategy, "the Canada Revenue Agency could seek to apply the general anti-avoidance rule."

The Act generally provides that a partnership is neither a person nor a taxpayer and is thus not liable to tax. However, subsection 102(2) deems a partnership to be a taxpayer for the purposes of specific sections of the Act, including section 96, which requires all income from business to be calculated at the partnership level (as if the partnership were a separate person) and then allocated to and taxed in the hands of its partners. Paragraphs 96(1)(f) and (g) provide that the income earned or the loss incurred by the partnership should retain its characteristics in respect of its source and nature. If a taxpayer is a partner of a limited partnership, subsection 96(2.1) applies to limit the amount of losses that the partner may claim, to the extent that such losses exceed the partner's at-risk amount. Furthermore, paragraph 96(2.1)(e) deems the excess loss to be an LPL of the taxpayer; paragraph 111(1)(e) generally provides an indefinite carryforward and permits the loss to be deducted in subsequent years to the extent that the taxpayer's at-risk amount has increased and is sufficient to cover the LPL.

From 1996 to 2009, the taxpayers in Green were limited partners in a limited partnership (MLP), and MLP was in turn a limited partner of other limited partnerships (the PSLPs). For all of those years, each PSLP incurred business losses, which were mostly allocated from the PSLPs to MLP and from MLP to the taxpayers. Until the end of 2008, the taxpayers' at-risk amount in MLP and MLP's at-risk amount in each PSLP were nil. Over the years, the taxpayers added the allocated losses to their LPL. The taxpayers' at-risk amounts in MLP increased at the end of 2009 as a result of a capital gain allocation by MLP. Therefore, each taxpayer claimed a portion of the previously accumulated LPL. The issue was whether subsection 96(2.1) should apply to limit the business losses to flow through from each PSLP to MLP, and then from MLP to the taxpayers, thereby restricting the loss claimed by the taxpayers.

The TCC rejected the Crown's argument that the business loss incurred in the year by the PSLPs, once deemed to be an LPL, will be trapped in MLP because a partnership is not a taxpayer for the purposes of paragraph 111(1)(e) and thus cannot carry forward the LPL for deduction in subsequent years. The TCC further concluded that the purpose of the at-risk rules
is not to deny absolutely the losses in excess of a limited partner's at-risk amount but, rather, to defer deduction of the excess until a time when the partnership has generated income or the partner's at-risk amount has increased for some other reason.
Thus, the taxpayers were allowed to claim a portion of the LPL to the extent of the increase in their respective at-risk amounts in MLP.

The FCA rejected the Crown's appeal, reiterating that
Parliament did not intend for a partnership that is a member of another partnership to compute income. Rather, Parliament intended for the sources of income (or loss) to be kept separate and retain their identity as income (or loss) from a particular source as they are allocated from one partnership to another partnership and then to the partners of that second partnership.
Therefore, the business losses incurred by a PSLP should maintain their characteristics both in MLP and after their allocation by MLP to the taxpayers.

Some taxpayers may be considering tax planning that is based on this decision. Suppose that a taxpayer is a partner of a general partnership (GP) and the GP is in turn a limited partner of a limited partnership. Because the at-risk rules do not apply to partners of a general partnership, business losses realized in a given year by the limited partnership will flow through to the GP, and the taxpayer will be entitled to claim without restriction the business losses allocated thereto from the GP.

Hiu Tung Cheung and Anna Chelstowska
Ernst & Young LLP, Montreal

Canadian Tax Focus
Volume 7, Number 3, August 2017
©2017, Canadian Tax Foundation