The allocation of partnership income and loss among partners is typically established by the governing partnership agreement. Notwithstanding the partners’ agreement, subsections 103(1) and 103(1.1) of the Income Tax Act (ITA) allow the Canada Revenue Agency (CRA) to adjust partnership allocations if such allocations are considered unreasonable. Recently, the Tax Court of Canada (TCC) in Aquilini (Estate) v. The Queen, 2019 TCC 132 concluded that allocations must be made according to objective business considerations under subsections 103(1) and 103(1.1) rather than subjective circumstances such as family situations or estate planning.
Aquilini facts and issues
The Aquilini family (appellants) owns a multi-million-dollar real estate portfolio via complex holding structures. The appellants decided to reorganize the family holdings in 2001 to credit proof assets and build wealth for future generations. As a result of the restructuring, all the family business assets were brought under one umbrella partnership, The Aquilini Investment Group Limited Partnership (AIGLP). Four family trusts (one for each of the three brothers and one for their elderly mother) were established to own partnership interests in AIGLP.
The following general allocation of partnership income and loss was established by the reorganization under AIGLP. The three brothers, directly and indirectly through their trusts, who contributed a total of 23.73 per cent of the AIGLP partnership capital, were allocated 17.34 per cent of distributions up to $1,000,000. The mother, directly and indirectly through her trust, who contributed only 8.84 per cent of the partnership capital was allocated 35 per cent of distributions up to $1,000,000. Further, the risk of losses was to be borne by the brothers who were active in the business because it was the father’s wish to not devalue the mother’s interest as she was elderly and only had limited participation in the business.
Following the reorganization in 2005, AIGLP acquired the Vancouver Canucks. To fund the acquisition, AIGLP sold some of the properties in its portfolio. The sale of the properties resulted in taxable capital gains and so the appellants sought advice to lower their tax burden. The appellants acquired an insolvent company with tax losses and appointed the insolvent company as a beneficiary of the four family trusts. Pursuant to the AIGLP allocation provisions, the bulk of the capital gains were allocated to the family trusts which in turn each elected to distribute the gains to the insolvent company. In this way, most of the taxable gains were then offset by the insolvent company’s available net capital losses. The Minister found this allocation to be unreasonable under subsection 103(1.1) of the ITA, or in the alternative, under subsection 103(1). The Minister’s reassessment allocated the partnership’s taxable income and losses pro rata in accordance with the partners’ initial capital contributions.
Anti-avoidance, reasonableness and principal purpose test
Income and loss allocations made to partners may be subject to reallocation by the CRA. Under subsection 103(1.1) of the ITA, where non-arm’s length partners agree to share any income or loss of the partnership and where such sharing of income or loss is not reasonable in the circumstances having regard to the capital invested in or work performed for the partnership or other relevant factors, the CRA may, notwithstanding any agreement, deem the allocation of income or loss to be the amount that is reasonable in the circumstances.
Judge Pizzitelli applied a contextual approach to the interpretation of subsection 103(1.1): “there is no requirement that there be a reduction in taxes paid or a postponement thereof…it is enough that [profit and loss shifting among related parties] is done.” The object and spirit of subsection 103(1.1) derives from the theory that a taxpayer should be taxed on its own income. Thus, partners must report their share of partnership income and a shifting of amounts would be inconsistent with that principle.
The TCC then continued to explore the reasonableness of AIGLP’s income and loss allocations. Because subsection 103(1.1) requires consideration of “other relevant factors” in determining the reasonableness of the allocation, the appellants asserted, “all circumstances, including personal family circumstances and personal estate planning goals must be considered.” This approach was, however, rejected by the TCC because the test is an objective one and limited to whether a reasonable business person, with business considerations in mind, would have made the allocation. The proper approach excludes factors that relate to personal or non-arm’s length relationships between family members, or estate planning elements that are inconsistent with the objective reasonable standard.
While subsection 103(1.1) specifically addresses non-arm’s length situations, the reasonable business person would only make business decisions that are in her own business interests. Despite family involvement in this case, the reasonableness test cannot take into consideration all personal factors as doing so would “effectively neutralize that objective test.” Other relevant factors when determining reasonableness are limited to “specific capital invested in or work performed for the partnership [...] namely factors relevant to the carrying on of business that bear a relationship to the income or loss thereof.” The TCC concluded that the only relevant factors a reasonable arm’s length business person would care about are capital invested, work performed for the partnership and risk.
In this case, AIGLP’s allocation formula was found to be unreasonable because the distribution to the mother was vastly disproportionate to her contribution. The brothers even admitted that this distribution formula would not make sense if third parties were involved. Further, evidence was clear that the brothers performed most of the work for the partnership and the mother had a very limited role. The brothers were rewarded for their contributions with net loss allocations. The judge found that a reasonable business person would not accept such an allocation. The TCC therefore concluded that the Minister’s reassessment and reallocation of losses based on initial capital contributions was reasonable.
The TCC also touched on the alternative subsection 103(1) argument which, similar to subsection 103(1.1), authorizes CRA to reallocate partners’ income or loss from a partnership to “reasonable” amounts having regard to certain circumstances. Subsection 103(1) differs from subsection 103(1.1) in that it does not require members of the partnership to be related. Further, subsection 103(1) has a purpose test requiring that the principal reason for the agreement be the postponement or reduction of tax. In the TCC’s view, the purpose of the allocations was to distribute almost all of the trusts’ taxable capital gains to a third party beneficiary with a large balance of available net capital losses, thereby offsetting the taxable capital gains. This allocation reduced the taxes that would otherwise be payable by the family. The TCC therefore found that the allocations were made for the purposes of reducing tax and, based on the same factors used to consider subsection 103(1.1) (i.e. capital invested, work performed for the partnership and risk), subsection 103(1) applied to AIGLP’s unreasonable allocation of income and losses.
Partnership allocations to be supported by objective factors
Taxpayers should be mindful that the CRA has discretion to change partnership profit and loss allocations that it deems unreasonable. Partnership allocations should be supported by factors such as capital invested and appropriate work contributions. Subjective factors that would not be of concern to the reasonable business person, such as estate planning objectives and family considerations, should not be relevant to the reasonable allocation test.