The Deemed Gain Problem
The Income Tax Act contains rules (in Subsection 40(3.1)) that trigger a capital gain most commonly to a limited partner of a limited partnership, when the Adjusted Cost Base (“ACB”) of the member’s partnership unit is negative at the partnership’s fiscal year-end.
How It Arises – A Timing Issue
Partnership distributions reduce the ACB at the time of the distribution whereas income allocated to the unit adds to the ACB one day after the year-end of the partnership. Thus, paying a large profit distribution to a limited partner before the year-end of the limited partnership may result in a negative ACB and trigger this gain. There is generally a tax remedy in that an elected deemed loss can be triggered once the ACB goes positive at the end of the next year of the partnership. The deemed loss can be carried back to offset the deemed gain of the prior year. However, this causes compliance, complexity and cash flow issues to recover tax on the deemed gain.
The Work Around and the Tax Risk
To avoid these rules, taxpayers have characterized distributions to limited partners temporarily as loans. CRA previously expressed uncertainty whether loans to partners exist at law and that even if they do, the words in the Income Tax Act are broad enough to treat loans in lieu of distributions as a reduction of ACB, thus triggering a gain.
Comfort from CRA to Support the Work Around
Recently, at the 2022 APFF Roundtable (Q.5), CRA expressed a change in perspective that can give taxpayers greater comfort on the tax position of temporary loans in lieu of profit distributions. CRA has expressed that they will generally accept the existence of loans and not trigger the deemed gains rules when certain criteria are met most notably, that the loans (1) are temporary and repaid shortly after the year end of the partnership, (2) relate solely to profit distributions, (3) do not relate to a withdrawal of capital contributions and (4) are primarily made to avoid the deemed gain issue. The favourable position does not apply to partnerships that are tax shelters.
Taxpayers should ensure the details of CRA comments are adhered to, that the partnership agreement permits the existence of loans to partners and that loans and repayments are legally effective with appropriate documentation.
Taxpayers must be aware that this CRA statement is not law. Relying on an administrative position of CRA is subject to CRA taking a differing view at a later time or trying to differentiate the facts from their technical statement. This is not “fool-proof” but helpful and appreciated as a welcomed practical perspective by CRA to assist taxpayers in obtaining a better result to a cumbersome nonsensical compliance issue.
Rhonda Pomerantz CPA, CA & Jim Witty CPA, CA Miller Bernstein LLP, Oct 19 2022