the great escape · 2013-02-19 · taxation of partnerships aaron grinhaus 1 i. the great escape:...

The Great Escape:

Freeing Limited Partnership Losses from the Entrapping

Provisions of Section 96(2.2).

By: Aaron Grinhaus

Table of Contents

I. The Great Escape: Freeing Deductions from the Income Tax Act......... 1

II. The Iron-Wrought Shackles: The Language of Section 96(2.2)............. 3

III. The Mirror Handcuff Challenge: CRA IT Bulletins............................... 6

IV. Demystifying the Language: The Courts‟ Interpretations...................... 8

V. Inside the Ghost House: Scholarly Commentary and Revealing

Observations........................................................................................... 15

VI. Secrets Revealed..................................................................................... 17

VII. Grand Finale............................................................................................ 20

Bibliography...................................................................................................... 22

Taxation of Partnerships Aaron Grinhaus

1

I. The Great Escape: Freeing Deductions from the Income Tax Act

Harry Houdini was one of the greatest escape artists of all time. When asked how he was

able to defy all sceptics by escaping from the most contrived shackles and prisons without

having access to any physical escape tools, he replied “my brain is the key that sets me free.”1

Indeed, lawyers, accountants and financial planners continue to use that most mysterious and

perspicacious of bodily organs to bypass the most elaborate restrictions contrived by law makers

to restrict the circumvention of potential tax dollars from government coffers. Divining methods

which allow tax dollars to escape from the imprisoning provisions of the Income Tax Act (the

“Act”)2 can be an arduous task, but not an impossible one.

The Act is among the more expressly defined products of Parliament, its jurisprudence

being comprised of, and augmented by, a document as thick as a phone-book, decisions from a

court exclusively created for its interpretation, bulletins (“IT Bulletins”) issued by the enforcing

Canada Revenue Agency (the “CRA”) and various tax law specific periodicals and other

publications. Despite this overly contrived piece of legislation and wealth of supplemental

interpretation there is a cavernous and oft overlooked gap with respect to one particular area of

the system created by the Act: the taxation of partnerships.

Partnerships are flexible, malleable, and not subject to many of the harsh provisions

applicable to corporations. They are created by contract, not by statute, and have the benefit of

allocating losses and profits at the discretion of the partners, in accordance with the partnership

agreement. They have little use for smoke and mirrors, since the Act is silent on many issues that

are covered with respect to corporations. That having been said, the Act is not completely silent;

the legislature has directed its focus on a few key aspects of the allocation of losses and profits in

1 “Harry Houdini Quotes”, Houdini Museum Website, online: < http://www.houdini.org/interior-harry-houdini-

attractions-pocono-poconos-scranton.html >. 2 Income Tax Act, R.S.C. 1985, (5th Supp) c.1.


2

partnerships, and as a result, a new illusion was created: the legal fiction of a “partnership” being

a separate person under the law.3 To facilitate this illusion and impede, if not detain, the

reduction of the individual partner‟s taxable income, the legislature sought to create a set of rules

to deter any sleight of hand attempted by the partners.

One such rule is that found in section 96 of the Act: the At-Risk Amount (“ARA”) rules.4

The ARA rules are designed to calculate, and effectively reduce, the amount of “the taxpayer‟s

investment at risk in the partnership.”5 Broadly speaking this amount is determined under section

96 of the Act by determining “the partner‟s ACB for the partnership interest, increased by the

partner‟s share of the current year‟s income from the partnership, and reduced by all amounts

owing by the partner ... to the partnership ... and ... any amount or benefit to which the partner is

entitled”.6 If the taxpayer‟s partnership loss exceeds the ARA then it is not deductable in the

year, and thus must be carried forward until such time as the ARA exceeds the loss amount.7

While the calculation rules are complex, they are somewhat objective, except for the broad and

overarching provision in section 96(2.2)(d).

The ARA rules are designed to expose the amounts that the partner actually does and

does not have at risk in the partnership in order to determine what deductions he or she is entitled

to make. However, the overarching, broad language in 96(2.2)(d) creates problems for the

interpretation and practical application of the section. Although the Act creates a lock-box

designed to minimize or defer deductible partnership losses, court decisions and commentary on

the section reveal that there are ways to structure such losses in such a way as to avoid running

3 R.S.C. 1985, (5th Supp), s. 96(1)(a). 4 Ibid. 5 Elizabeth Johnson and Genevieve Lille, Understanding the Taxation of Partnerships, 6th ed. (Toronto: CCH Canadian Limited, 2010) at p. 198. 6 Ibid. at p. 197-198. 7 R.S.C. 1985, (5th Supp), s. 96(2.1).


3

afoul the contrived restrictions of the Act. It is this author‟s intention to demonstrate how one

can break free of the imprisoning provisions of 96(2.2)(d) in order to reap the benefits of such

loss deductibility in the taxation year of the partner‟s choosing.

The paper will begin with a brief overview of the ARA provisions and their operation in

law. The author will then briefly survey the jurisprudence and IT Bulletins in order to

demonstrate how the prison has been constructed and where the cracks and crevices appear. The

paper will then explore the scholarly opinions available on this section as well as relevant

criticism and commentary. Finally, the paper will conclude by freeing the taxpayer with methods

of escape designed to liberate the taxpayer from the restrictions imposed by the Act. The purpose

of this paper is to demonstrate that, regardless of the broad and overarching language in section

96(2.2)(d), which is designed to minimize the partner‟s ARA for the purpose of calculating loss

deductibility, the affairs of the taxpayer can be structured in order to permit losses to be deducted

in the taxation year at the discretion of the taxpayer. As we unlock the mysteries of the Act,

please remember that, though one may sustain severe paper cut injury, you may try this at home.

II. The Iron-Wrought Shackles: The Language of Section 96(2.2)

The relevant provisions of section 96(2.2) read as follows:

For the purposes of this section ... the at-risk amount of a taxpayer, in

respect of a partnership...is the amount, if any, by which the total of (a)

the adjusted cost base to the taxpayer of the taxpayer‟s partnership

interest at that time ... (b) ... the taxpayer‟s share of the income of the

partnership from a source for that fiscal period computed under the

method described in subparagraph 53(1)(e)(i), and

(b.1) ... the amount referred to in subparagraph 53(1)(e)(viii) in respect of

the taxpayer for that fiscal period

exceeds the total of

(c) all amounts each of which is an amount owing at that time to the

partnership, or to a person or partnership not dealing at arm‟s length with

the partnership ... and


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(d) any amount or benefit that the taxpayer or a person not dealing at

arm‟s length with the taxpayer is entitled, either immediately or in the

future and either absolutely or contingently, to receive or to obtain,

whether by way of reimbursement, compensation, revenue guarantee,

proceeds of disposition, loan or any other form of indebtedness or in any

other form or manner whatever, granted or to be granted for the purpose

of reducing the impact ... of any loss that the taxpayer may sustain

because the taxpayer is a member of the partnership ....8

A plain reading of the section reveals that it is intended to prevent the deduction of losses in

excess of the investment of a limited partner (“LP”). In other words, even though the partnership

is taxed as a separate individual,9 the LP may personally claim part of the loss as his or her own

share in order to reduce his or her own taxable income. The ARA rules operate to ensure that the

amount being claimed by the individual partner (i.e. the amount claimed as a business loss by the

LP personally) does not exceed the amount actually “at risk” (i.e. the LP‟s contribution) in the

business, thereby creating a deduction which exceeds the LP‟s contribution. These rules were

introduced because “[t]he flow-through nature of a partnership historically made partnerships a

popular vehicle for tax-motivated investments that relied on the allocation of losses to investors

to generate a favourable investment return. The „at-risk‟ rules and the „tax shelter‟ investment

rules were introduced in the mid-1980s to curtail this use of partnerships.”10

The ARA rules are

therefore comprised of calculations designed to minimize the ARA.

The calculation used to reduce the ARA in section 96(2.2) is broad and encompasses a

number of factors. Simply put, the ARA is expressed as a difference which is determined by

effecting two calculations and subtracting one from the other as follows:

8 Ibid., s. 96(2.2). 9 Ibid., s. 96(1)(a).

10 Elizabeth Johnson and Genevieve Lille, "The Taxation of Partnerships in Canada" Bulletin for International Taxation (August/September 2009), CTF: pp. 381-394 at 381.


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Calculation A: Adjusted Cost Base (“ACB”) of the taxpayer‟s

partnership interest at that time, with adjustments made (i) where that

interest was received by a transferor other than the partnership in

accordance with 96(2.3), and (ii) to exclude the taxpayer‟s share of

defined energy resource related amounts (as determined in

subsections 53(1)(e)(i) and (viii)), entitlements to insurance with

respect to a liability of the partnership, and benefits arising as a result

of the death of the LP; minus

Calculation B: Any amount that the LP owes the partnership (not

including limited recourse debts and the cost of a tax shelter

investment under section 143.2), and “any amount or benefit that the

taxpayer or a person not dealing at arm‟s length with the taxpayer is

entitled”, at any time, in any form “granted ... for the purpose of

reducing the impact ... of any loss that the taxpayer may sustain

because the taxpayer is a member of the partnership”.11

The amount by which calculation A exceeds calculation B is the ARA, and the amount by which

the ARA exceeds the LP‟s losses is the amount that may be deducted in the taxation year of the

LP. This shall serve to demonstrate the strength of the shackles in which the taxpayer is locked

while trying to determine the amount the LP may successfully liberate for the calculation of his

or her taxable income.

Despite the wide net cast by section 96(2.2)(d), there are some advantages and weak

points in the way the legislation is drafted. First, any losses which cannot be claimed “can be

carried over to and used in other years to offset the taxpayer‟s income from the limited

partnership for those years”.12

This means that the taxpayer can realize a significant advantage in

later years should the ARA substantially increase by some means other than by the further

investment of capital. Furthermore, the section itself creates a limitation that the reduction of the

ARA is only with respect to any amounts “granted ... for the purpose of reducing the impact ... of

11

R.S.C. 1985, (5th Supp), s. 96(2.2)(c), (d) (emphasis added). 12 Canada Revenue Agency, Interpretation Bulletin IT-232, “Losses - Their Deductibility in the Loss Year or in Other Years.” (4 July 1997).


6

any loss that the taxpayer may sustain because the taxpayer is a member of the partnership”.13

This almost looks like a subjective test rather than an objective one, which potentially unlocks

the door to creative financing justification. In addition, the seemingly ironclad section broadly

encompasses a variety of possible “purposes” which, in conjunction with the subjective test,

causes the section to appear vague and overbroad. The courts and the commentary suggest that,

though the locks have been masterfully crafted, there are several places to hide keys and the

space between the bars may be wide enough to squeeze through.

III. The Mirror Handcuff Challenge: CRA IT Bulletins

In 1904, the London Daily Mirror challenged Houdini to escape from handcuffs that were

allegedly crafted over a five year period by a master craftsman. Houdini accepted, and during a

highly publicized event which witnessed the showman struggling behind a white “ghost house”

screen for over an hour, he ultimately emerged, liberated from the shackles. Some say he was

slipped the key by his wife when she kissed him during the performance; others contend that The

Mirror was in on the performance from the start.14

In any case, the odds were stacked against

him and he was able to transform the despondent circumstance into a magnificent spectacle.

In the twenty-seven years during which this most recent incarnation of the Act has been

continually improved, Section 96 has been amended and buttressed to prevent exploitation from

inside the ghost house. In addition to modifications in the language, the courts and the CRA have

made attempts to clarify the language and its specific application within the framework of the

expansively broad provisions.

The most relevant CRA IT Bulletin is IT-232R3, which addresses, inter alia, “a loss from

an office, employment, business or property, including a limited partner‟s share of a loss of a

13 R.S.C. 1985, (5th Supp), s. 96(2.2)(d). 14 "Harry Houdini" Wikipedia, online: < http://en.wikipedia.org/wiki/Harry_Houdini >.


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limited partnership”.15

This IT Bulletin attempts to clarify the operation of 96(2.2) by stating

that:

A limited partnership loss cannot be carried back, but it can be carried

forward indefinitely under paragraph 111(1)(e). However, by virtue of

that paragraph, no amount is deductible in the year of loss application

in respect of a limited partnership loss except to the extent of the

taxpayer's “at-risk amount” in respect of the partnership (as

determined under subsection 96(2.2)) as at the end of the last fiscal

period of the partnership that ends in the year of loss application, less

certain amounts specified in subparagraph 111(1)(e)(ii).16

This explanation is lacking in that it does not elaborate on or clarify the calculation required to

determine the ARA.

In order to clarify the mechanics of the calculation the CRA released a hand book to

assist the LP in donning the handcuffs in the proper fashion (the “Guide”). The CRA begins by

giving the ominous warning that “[c]alculating the ARA can be very complex; you have to

consider many rules”, setting the tone for what is to come.17

The Guide walks the reader through

the calculation as follows:

In simplified terms, a limited partner‟s ARA is calculated under

subsection 96(2.2) as: (a + b + b.1) minus (c + d), where:

a is the ACB of the limited partner‟s interest in the partnership

at the time of calculation...Note Subsection 96(2.3) applies

where the limited partner is not the first owner of the interest;

b is any partnership income allocated to the limited partner for

the fiscal period;

b.1 are [resource related] amounts...;

c is any amount that the limited partner owes to the partnership (other

than any [specified] amount ...);

15 Canada Revenue Agency, Interpretation Bulletin IT-232, “Losses - Their Deductibility in the Loss Year or in Other Years.” (4 July 1997). 16

Ibid. at para. 18(e). 17 Canada Revenue Agency, Tax Guide T4068 (E) Rev. 11, “Guide for the Partnership Information Return (T5013 Forms)” (2011) at 77.


8

d is any amount or benefit the limited partner, or a person not dealing

at arm‟s length with the limited partner, is entitled to get in any form

or manner, immediately or in the future and absolutely or

contingently, to reduce the impact of any loss to the partnership

interest.18

The examples which follow take the ARA as a given, with the calculation not referred to or

elaborated upon. To make things even more confusing, the Guide uses the word “correspondent”

where it should be using the word “corresponding”.19

One is a noun, the latter an adjective, and

neither contributing to a clear understanding of the ARA calculation‟s constituent parts. The

explanation has therefore been left to the infinitely more articulate courts, which have had better

luck in de-mystifying the secrets of the ARA determination.

IV. Demystifying the Language: The Courts’ Interpretations

Few cases have directly, and none exclusively, addressed the meaning of the words in

section 96(2.2)(d); however, several cases have touched on different parts of the section.

One such case was McKeown.20

In McKeown the Tax Court of Canada (“TCC”)

considered, inter alia, the question of whether an entitlement arising under section 96(2.2)(d)

could be used to reduce the impact of losses in the year in which the entitlement occurred, not in

a future year.21

In this case the issue was whether a taxpayer, who was involved in two

partnerships which operated only for the purpose of obtaining scientific research and

experimental development (“SR&ED”) tax credits, was entitled to deduct losses incurred in the

process of exploiting the SR&ED tax credits, where no business activity was carried out in the

partnerships and there was no view to profit.22

18 Ibid. at 77. 19 Ibid. at 79. 20

McKeown v. Canada, 2001 D.T.C. 511. 21 Ibid. at para. 331. 22 2001 D.T.C. 511.


9

The court considered many issues, among them the question of whether the word

“purpose” in the following part of section 96(2.2)(d) was subjectively or objectively determined:

“any amount or benefit [to which] the taxpayer ... is entitled ... [or] granted for the purpose of

reducing the impact, in whole or in part, of any loss that the taxpayer may sustain because the

taxpayer is a member of the partnership”.23

The taxpayer appellant argued that, in disposing of

his partnership interest for more than fair market value and in fact far more than his ARA, he

was not “reducing at all his full liability ... for any debt that [the partnership] might have incurred

during the period in which he was a member thereof”, stating further that:

For a member‟s entitlement to receive an amount to fit the description

in section 96(2.2)(d) of the Act, that entitlement must have been

granted to the member “... for the purpose of reducing the impact, in

whole or in part, of any loss that the taxpayer may sustain by reason

of being a member of the partnership or by reason of holding or

disposing of an interest in the partnership ....” The purpose of [the

buyer‟s] purchase of the appellant‟s shares “was not to reduce the

impact, in whole or in part, of any loss that the appellant may have

sustained by reason of being a member of [the partnership] or by

reason of holding or disposing of an interest in that partnership, but

rather to enable [the other partner] to recover the rights to the

[business] so that it could survive by trying to carry on with that

project on its own behalf”.24

In other words, the taxpayer argued that since the “purpose” was not to reduce the impact of a

partnership related loss, that he could not be considered a “limited partner” in accordance with

the provision.

The respondent CRA did not agree with this position. It argued that “the appellant had

such an entitlement ... because it was anticipated and planned, at least tacitly, that he would

dispose of his shares for a fixed amount exceeding their fair market value, which amount was

23 R.S.C. 1985, (5th Supp), s. 96(2.2)(d) (emphasis added). 24 McKeown v. Canada, 2001 D.T.C. 511 at paras. 333, 335.


10

determined in advance.”25

The court agreed, holding that “it is clear from the evidence that the

appellant behaved like a limited partner by not participating in decisions concerning the

management of [the partnerships]”, concluding “that the appellant must be considered a limited

partner within the meaning of paragraphs 96(2.4)(b) and 96(2.2)(d).”26

In this case the Court held

that, where a benefit is received, the subjective purpose of the benefit will be determined on the

facts rather than on the result alone. Though it did not work to the benefit of the appellant in this

case, the door was left open to a subjective analysis of the “purpose” element in section

96(2.2)(d).

The question of whether a “benefit” exists has also come into question before the courts.

In Brown27

the Federal Court of Appeal (“FCA”) considered, inter alia, whether a benefit was

derived as defined in section 96(2.2)(d), where the taxpayer purchased a partnership interest for

$10,000 worth of shares and debt related to goods, and within three years was granted the option

of redeeming his interest for $8,000.28

The redemption included the acquisition of the goods to

which the debt related, which was deemed to be a non-arm‟s length transaction and thus required

that the goods be valued at fair market value. The two issues which arose in Brown were whether

the redemption amount was in fact a benefit, and to what extent (and at what value) would the

option to acquire the goods form a benefit.

The Court held that only the objectively provable numbers would form part of the ARA

calculation, whereas the rest would not, stating that:

25 Ibid. at para. 363 [internal quotations omitted]. 26

Ibid. at paras. 415-416. 27 Brown v. Canada, 2003 FCA 192. 28 Ibid.


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[T]he evidence that was adduced as to the value of the shares causes me

to infer that the value is simply not ascertainable. I am of the opinion

that the evidence adduced on this issue demonstrates that the share

benefit is simply too vague to ascribe a value to it. While paragraph

96(2.2)(d) is worded broadly, it seems to me that, where, according to the

evidence, the amount of the benefit referred to is not ascertained or

ascertainable, paragraph 96(2.2)(d) cannot apply.29

In other words, since the value of the goods was vague and unascertainable, it was being valued

at nil, as opposed to the clear redemption value of the partnership interest. In this instance the

Court held that the objectively valued component of the taxpayer‟s partnership interest would not

form part of the ARA since the possibility of redemption negated its characterization as being “at

risk”. Since the value of the part that could actually be at risk, the goods, was unascertainable,

the Court affirmed its valuation as being nil, thus not contributing to the ARA and leaving the

taxpayer without the prospect of deduction.

Brown illustrates that valuation is a key element in determining the benefit for the

purpose of calculating ARA. If the taxpayer was able to show that the redemption value of

$8,000 did not exceed the actual value of the goods, then the difference would contribute to the

ARA and the taxpayer would be able to deduct losses in the current year. The taxpayer‟s

inability to demonstrate a clear valuation prevented the argument from being made. Valuation is

another key that can be used to unlock the deductibility of losses.

The courts further interpreted the language of the section in McCoy, where the Court held

that the parties acted at arm‟s length and were thus not subject to the provisions of section

96(2.2)(d).30

In McCoy the developer of a software program sold an interest in his software to a

partnership in exchange for promissory notes due at some date in the future. The partnership

continued to acquire an interest in the developer‟s software, which was ultimately not profitable,

29 Ibid. at para. 61 (emphasis added). 30 McCoy v. Canada, 2003 TCC 332.


12

and attempted to deduct the losses at the end of its fiscal period.31

The Minister of National

Revenue (the “Minister”) argued that the parties “acted in concert” to maximize the tax benefits

of the venture, and were thus not arm‟s length parties.32

The Court disagreed, holding that it is to

be subjectively determined whether a close business relationship should be interpreted as a

partnership:

[The developer] and the partnership ... each had their own interests – [the

developer] wanted the money and the partnership wanted the software ....

The evidence ... was that there was a good deal of bargaining ... about the

price. To say that the parties acted in concert is not meaningful in this

context. All it means is that both parties wanted to get the deal done. If

that is the sort of “acting in concert” that results in parties to a transaction

not dealing at arm's length then no business transaction between

independent persons would ever be at arm's length.33

The Court made clear that the analysis must be made in the context of the relationship,

subjectively: “[t]here was no common mind ... one must consider the matter at the partnership

level rather than at the partners' level.”34

This additional, malleable subjective test provides

additional wiggle room in the seemingly air-tight milk can.

The courts have also considered the question of whether a mechanism can be put into

place in order to back-stop section 96(2.2)(d) from being triggered, and whether the arm‟s length

test can be circumvented. In Howe, the TCC considered whether partnership units could be

subject to a price adjustment clause which stated that, if an option was exercised to redeem

partnership units, that they would be purchased for the lesser of a fixed amount representing their

ARA or fair market value, thus ensuring that any such redemption would result in a loss.35

In

other words, if the fair market value was less than the fixed amount, then the partners would

31 Ibid. 32 Ibid. at para. 67. 33

Ibid. at para. 70. 34 Ibid. at para. 69. 35 Howe v. Canada, 2004 TCC 719.


13

have suffered a loss; otherwise, the fixed amount ($1,080 per unit) was a ceiling for the value.

The business suffered losses and the partners exercised their options, subsequently deducting the

losses.

The CRA disallowed the deductions, arguing that “$1,080 was a floor and it wasn‟t a

ceiling, because everybody knew ... that the fair market value in these two years ... would always

come out to a number higher than 1,080.”36

The Court held that the calculation and cost

determination of the units did not result in “reducing the impact of any loss that they may have

sustained by holding or disposing of an interest in the partnership”.37

By setting a ceiling on the

value, however, a partner is able to ensure that its ARA is not exceeded. The Court held that this

was acceptable, stating that, since an outside agreement governed the value, the partners were

subject to the terms thereof:

[The company] was obligated to make an offer to acquire the partnership

units at the lesser of the fair market value and $1,080 per unit. Under this

formula, the price offered by [the company] could never exceed a unit‟s

fair market value at the time of the offer. The partners‟ risks fluctuated

directly with the fortunes of the partnership‟s business. ...[I]t is clear,

given the requirement that [the company made] an offer at the lesser of

$1,080 and the fair market value of a unit, that it was impossible for the

Appellants to receive any amount or benefit reducing the loss sustained

on the disposition of a partnership interest.38

The Court, therefore, allowed for a price adjustment clause in a related agreement to impact the

effect of section 96(2.2)(d) by influencing the fundamental ARA calculation and modifying the

determination of the fair market value.

Finally, to clarify the extent to which a benefit can be manipulated by agreement,

compare the results in Howe with the outcome in Docherty.39

In Docherty, the partners entered

36 Ibid. at para. 27. 37

Ibid. at para. 33. 38 Ibid. at para. 27. 39 Docherty v. Canada, 2005 FCA 93.


14

into a venture for the construction and operation of a multi-use facility, which was ultimately

never built.40

The partnership agreement contained a provision which stated that “partners were

not obliged to pay the bills of ... a company controlled by [one of the partners] until the

partnership generated revenues.”41

The appellant taxpayer argued, inter alia, that “the [relevant

provision in the] partnership agreement conferred no benefit on the taxpayers in any of the

taxation years in question, because it only applied when the [business] was operating.”42

The

partners in this case attempted to shield the benefit by interposing terms of the partnership

agreement.

The FCA affirmed the lower court‟s decision, rejecting the taxpayer‟s appeal. In its

decision it echoed the lower court‟s opinion:

since the partnership carried on business ... the reference ... should be

taken to refer to the operations of the partnership, not the operation of the

unbuilt development .... [T]he conduct of the parties was consistent with

the view that [the forgiveness provision] was already triggered,

particularly the fact that [the company] took no steps to recover ... debt

from the partners ... [and] that [the partner] wrote off part of its billings to

the partnership as bad or doubtful debts, yet continued to bill for services

rendered.43

In finding for the Minister, the Court took the view that the subjective actions of the partners

demonstrated that they in fact intended to utilize the provisions of the partnership agreement to

defray losses, unsuccessfully as compared with the efforts of the taxpayer in Howe.

The efforts to circumvent or challenge the provisions of the broad section 96(2.2)(d) have

not been without their commentators or criticism. Attempts at extrapolation and deconstruction

of the provisions and supplementary rules of the Act allow curious spectators to take a peek

behind the ghost house to see how the tricks are really performed.

40 Ibid. 41

Ibid. at para. 4. 42 Ibid. at para. 13. 43 Ibid. at paras. 16-17.


15

V. Inside the Ghost House: Scholarly Commentary and Revealing Observations

Since the inception of section 96(2.2) in 1986 there has been ongoing criticism and

commentary outside of that found in litigation. Behind the scenes, in academic circles, the great

legal minds have agonized over the best hiding places for the keys required to escape from this

water torture cell. Several interpretations have been born though few have become prevalent in

practice.

A few years after section 96(2.2) came into force, several articles attempting to expound

the provision were published. In one such article the author recommended that, when considering

the provision, one should “examine only those arrangements that are specifically directed at a

taxpayer‟s holdings in the partnership (rather than the partnership business)” when determining

whether the partner is a “limited partner” for the purposes of the provision.44

The author went on

to say that:

the phrase „granted for the purpose of reducing the impact‟ should be

considered the key phrase in this provision. For example, in interpreting

this section it should be argued that the rules do not apply to normal

covenants extracted in arm‟s length business relationships dealing with

such items as environmental, product liability and operational covenants

and indemnities. In this way, it may be possible to limit the application of

the section to benefits which are directed at providing the partner with

financial protection against his investment in the partnership.45

What the author is suggesting is that, in section 96(2.2)(d), the view should be towards a limited

scope of the provision which includes only the interests of the partner, as opposed to the

business. This is a fair interpretation and helps reduce the effect it may have on the overall

business of the partnership.

44

David W. Ross, “The At-Risk Principles And Rules” 1993 Prairie Provinces Tax Conference (Toronto: Canadian Tax Foundation) 5:1-47 at 5:22/23. 45 Ibid. at 5:22/23.


16

Other commentators have asserted that the broad language of section 96(2.2)(d) and the

related sections create irresolvable ambiguity. One author provides the following example of the

occurrence of such enigmatic difficulty:

Assume that a general partnership is formed on January 1, 2001 (“the

particular time”) with a fiscal period ending on December 31. On

December 31, 2004, the partnership is converted to a limited partnership.

Does paragraph 96(2.4)(a) operate to deem the partners limited partners

in 2001? The answer turns on the scope of the phrase “within 3 years

after that time.” Does “3 years” mean three calendar years (the wider

meaning), or does it mean the three consecutive periods of 365 days

ending after the particular time (the restricted meaning)? ... [T]he

interpretation of “year” could directly influence the amount of loss

deductible by the partners in respect of that year.46

The author goes on to suggest several possible interpretations, all of which are speculative and

ultimately leave the question to the courts.

Finally, in addition to the broad language of the provision at issue, there has also been

criticism with respect to its enforcement, and the uncertainty engendered thereby. A specific

article examined section 96(2.2)(d) in the context of limited recourse debts, or debts where the

partner\lender would have limited options for recovery should the borrower\partnership default

on such loan, and whether a benefit would be conferred for the purposes of the provision. It was

noted that “[t]he CRA has warned ... that if the intent is to refund the partner‟s original

investment at some convenient time once the non-recourse financing is in place, it may or may

not be appropriate (depending on the circumstances) for the at-risk rules to apply to limit the

partners‟ access to the tax deductions.”47

The author then turned to CRA bulletins in order to

ascertain the guidance required to avoid the application of the ARA rules.

46 Manu Kakkar, "Business Losses: General Partner Deemed a Limited Partner" (2004) 4:4 Tax for the Owner Manager at 7. 47 Stephen J. Fyfe, "The Taxation of Renewable Energy Investments in Canada", (2011) draft paper presented to the Canadian Tax Foundation's 63rd Tax Conference [page reference unavailable].


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After analyzing CRA publications the author‟s determination was, not surprisingly,

inconclusive. The author explained that “the CRA appears to have taken a pragmatic approach to

the application of subsection 96(2.2) ... to carve out “legitimate commercial transactions”, which

arguably is necessary because of the very broad language used in the provision.”48

The words

“pragmatic” and the identification of the broadness of the language of the provision precluded

the author from nailing-down any flags or guideposts which would assist the taxpayer in

identifying, and avoiding, the wrath of the CRA.

The information provided by the cases and the articles reveals that there are in fact

several hidden keys available to tax planners and partners looking to utilize losses despite section

96(2.2)(d)‟s catch-all verbiage. The following section will summarize these keys and expose

how the escapes are conducted.

VI. Secrets Revealed

Throughout this paper various holes, weaknesses and ambiguities have been revealed,

which tax planners may exploit in order to avoid the application of section 96(2.2)(d) and the

reduction of the ARA. The main theme throughout all the cases and articles was the broad and

ambiguous language contained in the provision and the vulnerability of the provision when one

mines down into the specific language. The language begs for interpretation and lacks specificity

where questions arise as a result of the near-barren jurisprudential landscape and the ostensible

supremacy of the IT Bulletins and CRA proclamations. The cases and commentary have also

revealed several weaknesses in the legislation.

One such weakness is the subjective “arm‟s length” test discussed in McCoy. Section

96(2.2)(d) requires the ARA be reduced by the amount of the benefit to which a person not

dealing at arm‟s length is entitled. McCoy identified that this “arm‟s length” analysis is a

48 Ibid.


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subjective one and is therefore subject to interpretation and argument. Determining whether

someone is generally dealing at “arm‟s length” is not a difficult determination to make; however,

due to the complexity of the business relationships which stem from partnerships dealing with

corporations and their interests in the business of the partnerships, ambiguities can be found, and

potentially engineered, to avoid the application of the provision. A prime example of this can be

found by comparing the facts in McCoy with those in Howe.

The Court in Howe allowed for the use of a price adjustment clause even though it failed

on the “arm‟s length” test. The price adjustment clause effectively manufactured the ARA by

pre-determining the redemption amount and the amount of the loss (should one be incurred).

This helped the partners avoid any surprises when the time came to claim a loss and allowed

them to effectively plan for how their deductions would be available when they were needed.

Creative use of this mechanism could help tax planners manage and anticipate the deductibility

of losses without reducing the ARA.

Another important tool for anticipating deductibility is the valuation principle found in

Brown. The ARA can be controlled by controlling the value of good acquired for the partnership

business. Not having a valuation could result in the ARA being set at zero; however, by creating

a valuation which takes into account present and future value, increase in value and

improvements, among other factors, the ARA can grow over time in many ways that are

acceptable by both the specific industry and generally accepted accounting principles. Increases

in value will help off-set any amounts captured under section 96(2.2)(d) which may be used to

reduce the ARA. The subjective nature of the valuation exposes the section to an additional

weakness. Though in theory a valuation is objective, in practice the mechanics of a valuation and

the factors used to derive it are very subjective.


19

An additional subjective interpretation of the language of the provision was found in

McKeown. The question of whether the “purpose” referred to in the section was to reduce the

impact of any loss has also been held to be a subjective one, and this has left a gaping hole in the

interpretation of the provision. The potential for structuring a relationship where the benefit is

granted for some other purpose, such as compensation, interest or even an amount unrelated to

any debts of the business of the partnership, if properly evidenced, would exploit this loop hole

in the provision.

In addition to the subjective interpretations of the language above there are other ways of

limiting the application of the section. As was mentioned above with reference to the several

scholarly articles, limiting the scope of the language in the provision also helps temper its broad

application. When arguing the overbroad language of the provision it should be asserted that the

language of the section must be interpreted narrowly such that the scope of the language does not

encompass the business itself, but the personal interest only of the partner. Finally, the ambiguity

with respect to interpretation and enforcement by the CRA is a factor as well, leaving questions

such as how the word “year” should be interpreted and what types of partnership activities will

be subject to audit.

The real key to the locks which encumber tax planners who struggle with attacks on ARA

is identifying and exploiting ambiguities in the language of the section. In some cases, being

aware of the clear exceptions to reveal a trap door under the stage is the best way to approach it.

Whether there is no benefit derived, the purpose is not to reduce the impact of a loss, and the

benefit is derived from an arm‟s length party are all important factors to determine while

attempting to liberate or exempt oneself from the imprisoning provisions of section 96(2.2)(d).


20

VII. Grand Finale

The purpose of this paper is to illustrate that, despite the seemingly water-tight language

in section 96(2.2)(d) of the Act, there are many ways to escape from its provisions. The broad

language itself is problematic. Interpreting the all-encompassing language of the provision has

proven to be a difficult task for the courts. This is exacerbated by the fact that the provision has

become the focus of litigation in only a small number of cases, and the CRA has made few

efforts to elaborate on the provision in its own pronouncements.

When the provision has been brought before the courts, the focus of the litigation has

been on the subjective nature of interpretation. In other words, the courts have been hesitant to

draw and overarching interpretation and have thus consistently concluded that the facts of the

specific case must govern whether certain words in the provision have detrimental meaning for

the taxpayer. As a result, the language has been narrowed by allowing exceptions which take into

account the subjective intent of the taxpayers.

The same conclusions can be drawn from scholarly commentators. The articles which

address the provision, which are also few and far between, consistently criticize the vague,

overbroad language of the provision. The criticism reveals that the courts have not adequately

elaborated on verbiage which may serve to truncate the applicability of the section, and thus the

trap door has been left open to interpretation and argument. Tax professionals are in the unique

position of being able to exploit these ambiguities for the benefit of the taxpayer. They can do

this by crafting structures and plans which circumvent the provision, and by creating an illusion

of objectivity for the CRA in a sea of smoke and mirrors. Just as the senses are subject to

manipulation, the CRA‟s senses may also be clouded by ambiguity and ostensible objectivity,


21

for, as the great Harry Houdini once said: “What the eyes see and the ears hear, the mind

believes.”49

49 “Harry Houdini Quotes”, Houdini Museum Website, online: < http://www.houdini.org/interior-harry-houdini-attractions-pocono-poconos-scranton.html >.


22

Bibliography

Legislation

1. Income Tax Act, R.S.C. 1985, (5th Supp) c.1.

Case Law 1. Brown v. Canada, 2003 FCA 192.

2. Docherty v. Canada, 2005 FCA 93.

3. McKeown v. Canada, 2001 D.T.C. 511.

4. McCoy v. Canada, 2003 TCC 332.

5. Howe v. Canada, 2004 TCC 719.

CRA Publications

1. Canada Revenue Agency, Interpretation Bulletin IT-232, “Losses - Their

Deductibility in the Loss Year or in Other Years.” (4 July 1997).

2. Canada Revenue Agency, Tax Guide T4068 (E) Rev. 11, “Guide for the

Partnership Information Return (T5013 Forms)” (2011)

Secondary Sources

1. Stephen J. Fyfe, “The Taxation of Renewable Energy Investments in

Canada”, (2011) draft paper presented to the Canadian Tax Foundation's

63rd Tax Conference.

2. Elizabeth Johnson and Genevieve Lille, “The Taxation of Partnerships in

Canada” Bulletin for International Taxation (August/September 2009), CTF:

pp. 381-394.

3. Elizabeth Johnson and Genevieve Lille, Understanding the Taxation of

Partnerships, 6th ed. (Toronto: CCH Canadian Limited, 2010)

4. Manu Kakkar, “Business Losses: General Partner Deemed a Limited

Partner” (2004) 4:4 Tax for the Owner Manager.

5. David W. Ross, “The At-Risk Principles And Rules” 1993 Prairie Provinces

Tax Conference (Toronto: Canadian Tax Foundation) 5:1-47.

Electronic Resources

1. "Harry Houdini Quotes", Houdini Museum Website, online: <

http://www.houdini.org/interior-harry-houdini-attractions-pocono-poconos-

scranton.html >.

2. "Harry Houdini" Wikipedia, online: <

http://en.wikipedia.org/wiki/Harry_Houdini >.

the great escape · 2013-02-19 · taxation of partnerships aaron grinhaus 1 i. the great escape:...

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