Is Your Partnership Allocation Method Reasonable? The Ability Of Tax Authorities To Reallocate Income And Losses Of A Partnership

• Published date: 21 October 2022
• Subject Matter: Tax, Income Tax, Tax Authorities
• Law Firm: Miller Thomson LLP
• Author: Mr Alexandre Chano and Stéphanie Pépin

Partnerships are frequently used in various legal structures as they can be a beneficial vehicle to address certain business needs. Despite the advantages of using a partnership, partners must nevertheless take into account the potential taxation issues that may arise.

A partnership is not taxed as a separate entity. Under subsection 96(1) of the Income Tax Act (the "ITA"), the income or losses of a partnership are first computed as if the partnership is a separate person and are thereafter allocated to the partners.¹

The partnership agreement will usually provide for a mechanism for the allocation of income and losses between the partners. It is important for partnerships to consider subsections 103(1) and 103(1.1) of the ITA when allocating income or losses to partners. More specifically, pursuant to subsections 103(1) and 103(1.1) of the ITA, the tax authorities have the ability, in certain circumstances, to reallocate income or losses amongst the partners. In the event of a successful adjustment by the tax authorities, the partners could be subject to significant unintended tax consequences.

Subsection 103(1) of the ITA - The purpose test

Where partners have agreed to share income and losses of a partnership in a certain way and the tax authorities determine that the principal reason for that agreement is the reduction or postponement of tax that might otherwise be payable, subsection 103(1) of the ITA allows the tax authorities to reallocate the income and losses of the partnership between the partners to an amount that is reasonable.

Unlike subsection 103(1.1) of the ITA (described below), subsection 103(1) may apply even if the partners of the partnership are dealing at arm's length. This purpose test has been interpreted by the courts in a strict manner such that the application of subsection 103(1) of the ITA does not necessarily require that there be an overall reduction or postponement of tax or that the reduction or postponement of tax accrues to the benefit of any particular partner. If the principal reason is to reduce one taxpayer's tax, it is sufficient for subsection 103(1) of the ITA to apply.² For example, in certain circumstances, should an allocation method merely displace tax consequences from a partner, an individual, to another, a trust, an entity that could be taxable at the highest marginal tax rate, there nonetheless exists a tax reduction in regards to the individual and accordingly, the application of subsection 103(1) ITA...