The Federal Court of Appeal Applies GAAR in a Partnership Loss Transfer Strategy: Canada v. 594710 British Columbia Ltd., 2018 FCA 166

Overturning the Tax Court of Canada’s (Tax Court) decision, the Federal Court of Appeal (FCA) ruled in 594710 British Columbia Ltd that GAAR is applicable in a loss utilization strategy where a new partner (Nuinsco) with a significant unused loss balance entered a partnership to facilitate an allocation of virtually all the partnership’s income, availing the former partners of taxes otherwise payable. In coming to this conclusion, the court determined whether the object, purpose, and spirit of subsections 96(1) and 103(1) were frustrated.

The Tax Court concluded that, under paragraph 96(1)(f), income may be allocated to persons who are members of a partnership at year end so long as the partnership agreement provides for it. The FCA disagreed and commented that the Tax Court’s interpretation is contrary to the object, spirit or purpose of subsection 96(1): Taxpayers cannot use 96(1) to allocate taxable income to its partners in a manner that does not assist the organizational structure of the partnership or the efficient conduct of the partnership business. This stems from an analysis of private law, case law and legislative history of 96(1) and its predecessors. Essentially both point to the notion that taxpayers cannot arbitrarily allocate income to partners devoid of what the partners are entitled to under private partnership laws.

The object, spirit or purpose of subsection 103(1) is to counter tax avoidance arrangements in which partners agree to share income principally for tax reasons, and the resulting allocation is unreasonable taking all the circumstances into account. The Tax Court determined that it is not within the object, spirit or purpose of subsection 103(1), by itself, to require a reallocation of income between current and former partners. The FCA disagreed stating the breadth of the language used in subsection 103(1) is contrary to the Tax Court’s conclusion; since income from a partnership is allocated at the end of a fiscal period based on the income for that period, subsection 103(1) must potentially apply to all persons who are partners during the fiscal period of a partnership.

The FCA ruled that 96(1)(f) was frustrated by relying on the following principles set out in Matthew:

  • The partnership rules under s. 96 are predicated on the requirement that partners in a partnership pursue a common interest in the business activities of the partnership, in a non-arm’s length relationship;
  • Although, on its face, s. 96(1) imposes no restriction on the flow of losses to its partners…it is implicit that the rules are applied when partners in a partnership carrying on a business in common, in a non-arm’s length relationship.
  • The purpose for the broad treatment of loss sharing between partners is to promote an organizational structure that allows partners to carry on a business in common, in a non-arm’s length relationship.

The FCA ruled that the allocation of income to Nuinsco for tax purposes –  which was divorced from Nuinsco’s economic entitlement under private law – frustrated the purpose of 96(1)(f) because Nuinsco’s allocation, and its participation in the partnership in general, in no way facilitated an “organizational structure that allows partners to carry on business in common”.

The court made it clear that there are many situations in which an allocation of taxable income and loss to persons who are partners at the fiscal year end is not abusive, but this is not one of them for the following reasons:

  • The taxable income allocated to Nuinsco far exceeded its economic entitlement.
  • From an operations perspective, the partnership conducted minimal business operations after Nuinsco became a partner.
  • Nuinsco had virtually no economic interest or risk in the underlying business of the partnership.

The FCA also ruled that 103(1) was frustrated because the transaction was devoid of any material substance (other than the deal fee that Nuinsco was entitled to for facilitating the transaction).

In short, allocation of income or losses to partners for tax purposes that do not correspond to a partner’s economic entitlement under private law is contrary to the subsections 96(1) and 103(1).

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