By Nizam Shajani, CPA, CA, MBA
November 6, 2020
The taxation of partnerships function on a flow through basis. Partnerships are not taxable, nevertheless the tax attributes of a partnership are allocated to the partners. The partners are therefore responsible to pay the tax on partnership income and may also clam the losses of a partnership. To accomplish this the Income Tax Act requires a computation of partnership income.
Income computed at the partnership level
“Where a taxpayer is a member of a partnership, the taxpayer’s income, non-capital loss, net capital loss, restricted farm loss and farm loss, if any, for a taxation year, or the taxpayers taxable income earned in Canada for a taxation year, as the case may be, shall be computed as if (a) the partnership were a separate person resident in Canada…” These general rules go on to detail the computation of income or loss for the partnership. As such, while recognizing that partnerships are not taxable entities, a mechanism is in place to calculate income or loss of the partnership at the partnership level to allow these amounts to flow through to the members of the partnership. The members of the partnership will report the taxable income or loss or other tax attributes in their taxable income.
To facilitate the reporting of partnership income by the taxpayer, the partnership must file the information Form T5013. This form allocates amongst the partners, the partnership income or loss, capital gains and losses and details the type of income earned by the partnership to facilitate proper reporting by the taxpayer on their own returns.
The share of income allocated to each partner should be reasonable, based on the circumstances. The Act precludes agreements to share income in unreasonable proportions where there are non-arms length parties involved. This reasonable allocation requirement has allowed courts latitude in the allocation of income and losses to the members of a partnership.
Just as income is allocated to the partners to increase their taxable income, partnership losses are allocated to partners to decrease taxable income in the same flow through character. While reasonable allocations have been acceptable by the CRA for General Partners (GPs), concerns arise in what is a reasonable allocation for partnership losses for limited partners of Limited Partners (LPs).
At risk rules
The structure of an LP became popular as the limited liability protected investors while making losses on start ups available to offset or shelter other taxable income. Prior to 1986, losses could be more than the amounts invested or risked by the limited partners. This occurred in instances where the LP borrowed funds or incurred payables where the individual limited partners had no obligations if the partnership was unable to make payment. An individual or corporation could therefore deduct more than the amount invested in the LP. When the partnership become profitable, there is always the option to roll the operations and assets into a corporation and issue shares.
At risk rules were introduce in 1986 in subsections 96(2.1) through 96(2.7) to limit the amount of partnership losses that could be allocated to limited partners in an LP.
Subsection 96(2.1) disallows the deduction of a loss by a limited partner that exceeds the limited partner’s at-risk amount. Subsection 96(2.2) provides the calculation of the at-risk amount.
Adjusted cost base
Income earned by the partnership is generally added to the adjusted cost base (ACB) of the partnership, along with adjustments for contributions and partner draws.
This commonly includes contributions of capital, the partners’ share of income or loss and capital dividends.
Table 1 Partner’s capital account
Partner’s Capital Account
Opening Balance Income (loss)Allocation Partner Contributions Partner Distributions Closing Balance
Partner A 50% $ 500,000 $ 400,000 $ – $ 250,000 $ 650,000
Partner B 25% $ 250,000 $ 200,000 $ – $ 250,000 $ 200,000
Partner C 25% $ 250,000 $ 200,000 $ – $ 250,000 $ 200,000
TOTAL 100% $ 1,000,000 $ 800,000 $ – $ 750,000 $ 1,050,000
Table 1 illustrates the partner capital account of a typical partnership. There are several additional adjustments to be added to the closing balances of the partner’s capital account to determine the ACB, including life insurance proceeds, and deemed capital gains due to negative ACB. Income allocations may also require adjustments for limited partners where there is a loss to the partnership. The table also illustrates the disconnect between income and distributions and how this affects the partner’s overall capital account balance.
Taxpayers will record their share of partnership income or losses regardless of receiving distributions. This may result in an incongruity between cash receipts and income reported by the taxpayer. Taxpayers are taxed on their income and not the amount of distributions received from the partnership. Distributions are accounted for in the ACB calculation or the partner’s capital account as illustrated in Table 1.
Tax filing requirements
Each partner will be taxed on their share of the partnership income and capital gains.
While all partnerships that carry on business in Canada must file a partnership information return, the CRA administrative policy only mandates this for the following:
• The absolute value of revenues plus expenses of the partnership is more than $2 million or the value of the assets is more than $5 million, or
• The partnership has a corporation or a trust as a partner, is part of a tiered partnership or the partnership invested in flow-through shares in which a Canadian resource business renounced expenses to the partnership.
The information return for partnerships is the T5013. This return includes income and losses of the partnership and maintains the source identity of the type of income or loss incurred.
Individuals who own partnership units file this income on their personal returns and are subject to tax at their personal tax rates at the amount and on the type of income allocated. Corporations who own partnership units file the partnership income on their corporate tax returns and are subject to tax at either the small business rate or the general tax rate.
Small business deduction
On March 22, 2016, the specified partnership income rules were amended to restrict the multiplication of access to the small business deduction (SBD). This was done to prevent businesses from multiplying access to the small business deduction using partnerships and corporate structures. The SBD tax rate is 11% in Alberta, compared to a 25% for the general business rate. The corporate partners in a partnership are required to share the small business limit of $500,000. As such, five equal corporate partners in a partnership that earns $1,000,000 in active business income would each pay tax on $100,000 at the SBD rate and $100,000 at the general corporate tax rate (assuming no additional income or deductions in their corporations).
Partnerships can be used effectively as a tax planning tool within a corporate organization. If you are a member f a partnership or contemplating setting one up, talk to our tax experts on how to effectively use your partnership.
This information is for discussion purposes only and should not be considered professional advice. There is no guarantee or warrant of information on this site and it should be noted that rules and laws change regularly. You should consult a professional before considering implementing or taking any action based on information on this site. Call our team for a consultation before taking any action. © 2020 Shajani LLP