2015-0567811E5 Thin cap rules for members of a partnership

Principal Issues: Whether the income inclusion under paragraph 12(1)(l.1) would apply to former members of a partnership, which are resident in Canada, in a particular taxation year in which the members disposed of their interests to non-resident corporations. In the particular situation, all of the income of the partnership for the fiscal period ending in the particular taxation year of the former members is allocated to the non-resident members

Position: Paragraph 12(1)(l.1) would apply.

Reasons: Subsection 96(1.01) deems the former members of the partnership to be members of the partnership at the end of the fiscal period of the partnership in which the former members ceased to be members. This means that although a person may have ceased to be a partner before the partnership’s fiscal period end, a portion of the partnership’s net income or loss is allocable to the person pursuant to subsection 96(1). Since subsection 96(1) applies, any interest paid or payable by the partnership pursuant to a legal obligation would be considered "deductible" by the partnership for the purposes of applying paragraph 12(1)(l.1) to the former members of the partnership.

Author: Gibbons, Jim
Section: 12(1)(l.1); 18(4); 18(7); 248(1)

XXXXXXXXXX                                J. Gibbons
                                                        2015-056781

July 28, 2015

Dear XXXXXXXXXX:

We are writing in response to your email dated January 26, 2015, concerning the application of paragraph 12(1)(l.1) of the Income Tax Act (the Act”). 

In particular, your questions relate to the following hypothetical facts:

*     NRco, a corporation that is not resident in Canada for the purposes of the Act, is the sole shareholder of Canco, a corporation resident in Canada, which in turn is the sole shareholder of Canco Sub, also resident in Canada. Canco and Canco Sub have taxation years ending on December 31.
*     Canco and Canco Sub (the “Original Members”) formed a partnership (the “Partnership”) under the laws of a Canadian jurisdiction, with Canco, holding a 99.9% interest and Canco Sub holding a 0.1% interest. The fiscal period of the Partnership ends on December 31.
*     The partnership agreement for the Partnership provides that the income and loss of the Partnership is allocated to members of the Partnership at the end of the fiscal period in proportion to their respective interests at that time. No income or loss of the Partnership for a particular fiscal period is allocated to persons who cease to be members of the Partnership prior to the end of the particular fiscal period.
*     NRco made an interest-bearing loan (“Loan”) to the Partnership which was then used to make a second loan to another Canadian corporation (“Canco2”) at a higher interest rate.
*     The paid-up capital, retained earnings and contributed surplus of Canco and Canco Sub are nominal.
*     Before the end of 2015, Canco and Canco Sub disposed of their interests in the Partnership to subsidiaries of NRco (the “NR Members”), corporations that are not resident in Canada for the purposes of the Act. The NR Members do not carry on business in Canada within the meaning of the Act, and the acquisition of the interests in the Partnership would not cause the NR Members to carry on business in Canada. The NR Members continue to hold the interests in Partnership to the end of 2015, such that all of the income or loss of Partnership for the 2015 fiscal period is allocated to the NR Members.

Your views

Subsection 96(1) of the Act provides, inter alia, that 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, or the taxpayer’s taxable income earned in Canada for a taxation year shall be computed as if the partnership were a separate person resident in Canada and as if the partnership’s fiscal period were its taxation year.  Based on your view that the NR Members would not be “taxpayers” for the purposes of the Act, it is your opinion that subsection 96(1) would not apply to the Partnership for its fiscal period ending December 31, 2015. Accordingly, the Partnership would not have “deductible” interest for purposes of applying paragraph 12(1)(l.1) of the Act to Canco and Canco Sub. In this regard, although you acknowledge that paragraph 96(1.01)(a) of the Act would deem Canco and Canco Sub to be members of the Partnership at the end of December 31, 2015, it is your view that it is unclear that this provision should apply for the purposes of applying paragraph 12(1)(l.1) only.

Our Comments

This technical interpretation provides general comments about the provisions of the Act and related legislation. It does not confirm the income tax treatment of a particular situation involving a specific taxpayer but is intended to assist you in making that determination. The income tax treatment of transactions proposed by a specific taxpayer will only be confirmed by this Directorate in the context of an advance income tax ruling request submitted in the manner set out in Information Circular IC 70-6R6, Advance Income Tax Rulings.

Paragraph 12(1)(l.1) and subsection 18(7) of the Act, among other provisions, were introduced in the 2012 Budget to extend the thin capitalization rules in subsection 18(4) to debts of a partnership owing to “specified non-residents.” Subsection 18(7) provides as follows:

 “Partnership debts — For the purposes of this subsection, paragraph (4)(a), subsections (5) to (6.1) and paragraph 12(1)(l.1), each member of a partnership at any time is deemed at that time

(a) to owe the portion (in this subsection and paragraph 12(1)(l.1) referred to as the "debt amount") of each debt or other obligation to pay an amount of the partnership and to own the portion of each property of the partnership that is equal to

(i) the member's specified proportion for the last fiscal period, if any, of the partnership ending

(A) at or before the end of the taxation year referred to in subsection (4), and

(B) at a time when the member is a member of the partnership, and

(ii) if the member does not have a specified proportion described in subparagraph (i), the proportion that

(A) the fair market value of the member's interest in the partnership at that time
is of

(B) the fair market value of all interests in the partnership at that time;

(b) to owe the debt amount to the person to whom the partnership owes the debt or other obligation to pay an amount; and

(c) to have paid interest on the debt amount that is deductible in computing the member's income to the extent that an amount in respect of interest paid or payable on the debt amount by the partnership is deductible in computing the partnership's income.”

The “specified proportion” of a member of a partnership for a fiscal period is defined under subsection 248(1) of the Act as “the proportion that the member’s share of the total income or loss of the partnership for the partnership’s fiscal period is of the partnership’s total income or loss for that period and, for the purpose of this definition, where that income or loss for a period is nil, that proportion shall be computed as if the partnership had income for that period in the amount of $1,000,000.” 

In the hypothetical scenario outlined in your letter, Canco and Canco Sub would determine their “specified proportion” for their 2015 taxation year based on the allocation of the Partnership’s income for the fiscal period ending December 31, 2014, since this is the last fiscal period of the Partnership ending on or before the end of the Canco and Canco Sub’s 2015 taxation year and at a time when they were members of the Partnership. Accordingly, subsection 18(7) would apply to deem Canco and Canco Sub to owe 99.1% and 0.1% of the Loan and to have paid the corresponding interest.  These amounts are taken into account in determining whether paragraph 12(1)(l.1) applies to Canco and Canco Sub in 2015.  This paragraph provides as follows:

“(l.1) Partnership – interest deduction add back — the total of all amounts, each of which is the amount, if any, determined in respect of a partnership by the formula

A x B/C – D

where

      A is the total of all amounts each of which is an amount of interest that is

     (i) deductible by the partnership, and

     (ii) paid by the partnership in, or payable by the partnership in respect of, the taxation year of the taxpayer (depending on the method regularly followed by the taxpayer in computing the taxpayer's income) on a debt amount included in the taxpayer's outstanding debts to specified non-residents (as defined in subsection 18(5)),

B is the amount determined under paragraph 18(4)(a) in respect of the taxpayer for the year,

C is the amount determined under paragraph 18(4)(b) in respect of the taxpayer for the year, and

       D is the total of all amounts each of which is an amount included under subsection 91(1) in computing the income of the taxpayer for the year or a subsequent taxation year, or of the partnership for a fiscal period, that may reasonably be considered to be in respect of interest described in A.”

In this case, it is our view that subsection 96(1.01) would apply to deem Canco and Canco Sub to be members of the Partnership at the end of 2015 based on the words of that subsection, which provide as follows:

“If, at any time in a fiscal period of a partnership, a taxpayer ceases to be a member of the partnership
(a) for the purposes of subsection (1), sections 34.1, 101 and 103 and paragraph 249.1(1)(b), and notwithstanding paragraph 98.1(1)(d), the taxpayer is deemed to be a member of the partnership at the end of the fiscal period…”.

As indicated above, subsection 96(1.01) applies for purposes of subsection 96(1), sections 34.1, 101, 103 and paragraph 249.1(1)(b). This means that although a person may have ceased to be a partner before the partnership’s fiscal period end, subsection 96(1) is applicable and a portion of the partnership’s net income or loss is allocable to the person pursuant to subsection 96(1).

In the case described above, it is our view that the interest paid by the Partnership on the Loan is “deductible” by the Partnership for the purposes of subparagraph (i) of element A in the formula in paragraph 12(1)(l.1) of the Act. Accordingly, paragraph 12(1)(l.1) of the Act will apply to include an amount in the income of Canco and Canco Sub regardless of whether any of the income of Partnership is included in their income under subsection 96(1) of the Act.

Other Comments

In this case, the partnership agreement does not provide for an allocation to be made to Canco and Canco Sub. However, subsection 103(1) or 103(1.1) may be applicable to a person who ceased to be a partner before the partnership`s fiscal year end but is deemed by subsection 96(1.01) to be a partner of the partnership at the end of the fiscal period.

Further, it might also be noted that the original structure could result in the application of section 245 of the Act.  In this regard, reference is made to the answer to question 12 of the Revenue Canada Roundtable of the 1992 Annual Conference of the Canada Tax Foundation, wherein we stated that “[w]here, however, it may reasonably be considered that the formation of the partnership was primarily to avoid the application of subsection 18(4) to interest paid on loans made to the partnership, the application of subsection 245(2) will be considered.” Also, if the series of transactions described above were undertaken to avoid payment of Part XIII tax on interest income derived from Canadian sources, the application of section 245 would be considered.

We trust our comments will be of assistance.

Yours truly,

G. Moore
For Director
International Division
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch 

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