CHOICE OF BUSINESS VEHICLES · may prefer to conduct itself as a proprietorship to avoid these costs. (c) The business may incur losses at the outset which the individual may wish

THE CANADIAN BAR ASSOCIATION

CLE Seminar "Tax Law for Lawyers"

May 30 to June 4, 2010

Niagara-on-the-Lake, Ontario

CHOICE OF BUSINESS VEHICLES

AN ANALYSIS AND COMPARISON OF INCOME TAX DISTINCTIONS

By

Richard Lewin

HEENAN BLAIKIE LLP

Bay Adelaide Centre

Suite 2900, 333 Bay Street

Toronto, ON M5H 2T4

Tel. (416) 360-3545 Fax 1 (866) 553-4346

Email: [email protected]

CHOICE OF BUSINESS VEHICLES

Ideally, the structure selected to carry on a business should depend strictly upon business

considerations and not necessarily be governed by income tax concerns. The computations of

income and income tax, however, may play a role in determining the type of vehicle that is used

to carry on a particular business activity. The objective of this paper is to set out some of the

principal income tax and capital tax issues that play a role in evaluating the choice of business

vehicle to be used.

How one carries on a business, however, should not be motivated solely by income tax

considerations. Legal liability attached to the business activity, administrative ease and

practicality should be equal if not overriding obligations. Time and space preclude a completely

exhaustive discussion of the subject and the articles set out in the bibliography annexed to this

paper may provide further insight into this complex issue. Tax rules tend to change with

frequent regularity and one must ensure that comments in any particular paper have not been

overridden by subsequent changes to the Income Tax Act.

The business vehicles which will be reviewed are

- sole proprietorships

- partnerships

- joint ventures

- corporations

- limited liability corporations or unlimited liability corporations

- “business trusts” or income trusts and what are commonly referred to as real estate

investment trusts and oil and gas royalty trusts, and

- mutual fund trusts

This paper will highlight the principal differences in the computations of income, taxable income

and income tax payable of the structures described above.

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PROPRIETORSHIPS

Introduction

The simplest way to carry on a business is by sole proprietorship. This requires the fewest

formal administrative steps that any business vehicle must undertake to commence business and

is likely the easiest to administer. Since the individual carries on business directly, it is the

individual who is subject to income tax. An individual may elect to carry on business as a sole

proprietor for a number of reasons including:

(a) A legal obligation to do so. In certain provinces certain professionals still are not

entitled to incorporate.

(b) The size of the business may not make it efficient to incorporate. Incorporation

requires a one-time incorporation and set-up fee cost, and annual costs of preparing

corporate records and filing government information returns. A smaller business

may prefer to conduct itself as a proprietorship to avoid these costs.

(c) The business may incur losses at the outset which the individual may wish to use to

offset against other sources of income. A more detailed discussion of this matter is

set out in the section entitled “Partnerships”.

(d) The Income Tax Act1 generally contains sufficiently broad provisions enabling an

individual to transfer a business either to a partnership or a corporation at a future

time without incurring an income tax liability. Transfers of real estate, in certain

circumstances, may not benefit from these rules.

An individual who elects to carry on business as a sole proprietorship is obliged, as are all

taxpayers, to compute income or loss from a business in accordance with the provisions of

1 R.S.C. 1985 (5th Supp.), c.1, as amended. All statutory references are to the Income Tax Act (the “Act”)

unless otherwise indicated.

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subdivision b of division A of part I. The income or loss from a business or property is the

individual’s profit or loss from that business or property.2 The remaining provisions of

subdivision b, together with other provisions of the Act, modify that computation of profit to

obtain a computation of income or loss, as the case may be. The concept of profit is not defined

in the Act. In Canderel Limited v. The Queen3, the Supreme Court held that the determination of

profit is a question of law and that generally accepted accounting principles are not rules of law

but interpretative aids

“In fact, the better view is that G.A.A.P. will generally form the very foundation

of the “well-accepted business principles” applicable in computing profit. It is

important, however, for the courts to avoid delegating the criteria for the legal test

of profit to the accounting profession, and therefore a distinction must be

maintained. That is, while G.A.A.P. may more often than not parallel the well-

accepted business principles recognized by the law, there may be occasions on

which they will differ, and on such occasions the latter must prevail.”4

Fiscal Period

An individual's taxation year is the calendar year.5 An individual

6 who carries on a business

7

(either as a proprietor or as a partner) generally is required to adopt December 31 as the end of

the fiscal period.8 An individual who carries on a prescribed business (none currently are

2 Subsections 9(1) and 9(2).

3 98 DTC 6100) (SCC).

4 Ibid. at page 6107.

5 Paragraph 249(1)(b).

6 An individual includes a trust for the purposes of the Act. Testamentary trusts and other individuals that

are tax exempt entities are excluded from this rule.

7 Ownership of rental property may not constitute a business, for example, unless ancillary services are

provided to tenants. See, for example, Walsh and Micay v. MNR (65 DTC 5293 Ex Ct).

8 Paragraph 249.1(1)(b). The definition of fiscal period in subsection 249.1(1) is the same as the previous definition

in subsection 248(1) except that it deems fiscal periods of individuals and certain partnerships to end on December

31. The rule as it applies to partnerships will be discussed under that heading.

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prescribed) or who carries on a business outside Canada may adopt a fiscal period that ends other

than on December 31 only for such business.

Income Tax Payable

The rates of income tax payable by an individual differ from the rates of income tax payable by a

corporation. Appendix “A” and Appendix “B” respectively set out the combined income tax

rates of the federal government and each of the provinces and territories of Canada for an

individual and for a corporation. Although corporate income tax rates often are lower than

individual rates, a distribution to an individual of corporate profits results in a second level of

income tax in the hands of the individual shareholder which may result in an overall greater

income tax liability than if the income had been earned directly by the individual. Individuals

who might otherwise wish to carry on an active business by way of proprietorship nevertheless

may find it advantageous to incorporate the business to reduce the overall income tax cost. The

changes to the Act creating the concept of “eligible dividend” adds to this advantage.

Take, for example, a business that earns $800,000 in a fiscal period which, if earned by a

corporation, would be “income of the corporation for the year from an active business”.9

Assume, further, that if the income were earned by a corporation, the individual would receive a

salary of $200,000. $500,000 of the corporate income of $600,000 is eligible for the “small

business deduction”.10

The following compares the 2010 calendar year income tax liability of

(i) an individual residing in the province of either Quebec or Alberta carrying on a business as a

sole proprietor with (ii) the income tax liability of the individual (in respect of the salary) and the

corporation in respect of its income.

9 Subsection 125(7). The definition includes the corporation's income for the year from an active business

carried on by it other than income from a source in Canada that is property. “Active business” is defined in this

same subsection essentially to mean any business carried on by a corporation other than a specified investment

business or a personal services business.

10

Section 125. Most provinces are increasing their small business deduction to this amount.

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EXAMPLE

PROPRIETORSHIP CORPORATION

QUEBEC

Individual tax $385,760 -

Individual tax salary - $88,000

Corporate tax (SBDI) - 95,000

Corporate tax (remaining income) - 29,900

Total Income Taxes $385,760 $136,800

Tax on distribution of remaining

corporate income of $387,100

($69,000 will be designated as an

eligible dividend)

349,700


ALBERTA

Individual tax $312,000 -

Individual tax salary - $78,000

Corporate tax (SBDI) - 70,000

Corporate tax (remaining income) - 28,020


Tax on distribution of $424,000

remaining corporate income of

($69,000 will be designated as an

eligible dividend)

108,400


This example shows that both in Quebec and Alberta the aggregate income tax liability of an

individual carrying on a business in a proprietorship exceeds the aggregate corporate and

individual income tax liability of a business carried on by a corporation. From a tax perspective,

clearly a corporation is preferable. To the extent that profits are distributed, that amount is

taxable as a dividend adding to the aggregate tax cost of a corporation operating a business.

Nevertheless, the aggregate tax cost still is less when a corporation is used to carry on a business.

Please note that the benefits are not so evident where the income is active but not eligible for the

small business deduction (see page 7-9).

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The extent of the actual additional income tax cost is difficult to quantify and depends, in part,

upon the delay between the earning of the profits and their distribution by way of dividend, and

whether the corporate income was eligible for the small business deduction. In addition, this

additional income tax liability may be reduced or even eliminated if the children and/or the

spouse of the individual are shareholders of the corporation taxable at below the maximum

marginal income tax rates and who may receive dividends without application of the income

attribution rules.

When tax reform was introduced in 1972, one of the underlying philosophies was the concept of

“integration” with respect to investment income. Simply put, this means that the tax effect on

investment income earned by a corporation and then distributed to a shareholder should be the

same as the tax effect on that investment income if earned directly by an individual. The

concepts of refundable dividend tax on hand, the dividend gross-up, the dividend tax credit and

the capital dividend account are mechanisms used to achieve this concept. Integration was

applicable only to private corporations and their shareholders. Specifically, the concept of

integration did not extend to the earning of business income.

The impetus for integration in respect of business income was the growing popularity of the

income trust. $1 of business income earned by an income trust resulted in a 46¢ tax cost to an

Ontario resident. If that $1 was earned by a corporation and the after tax profit was distributed

as a dividend, the combined corporate and shareholder tax was 56¢. To combat the income tax

advantages arising from the use of an income trust, amendments were introduced in 2006 to

provide for integration with respect to business income.. Prior to such amendments, all dividends

received by an individual from a Canadian corporation were subject to a gross up of 25% and a

dividend tax credit equal to 2/3 of that gross up (13.33% of the taxable dividend). To provide for

greater integration, the gross up in respect of “eligible dividends”11

was increased to 45% and

11

Definition in subsection 89(1).

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the tax credit became 11/18ths

of the gross up. Currently, the federal gross up is 44%12

and the

federal tax credit is 11/17th13

of the gross up.

A corporation resident in Canada is entitled to designate that a dividend paid by it be an “eligible

dividend”. In theory, all dividends from a corporation that is not a Canadian-controlled private

corporation (“CCPC”) should be considered eligible dividends. The concept of a low rate

income pool (“LRIP”) can affect the calculation of eligible dividends of a non-CCPC. Dividends

paid by a CCPC can be designated as eligible dividends to the extent of its general rate income

pool (“GRIP”). In simple terms, this pool will include 68% of business income that was not

eligible for the small business deduction and the aggregate of all eligible dividends it has

received.14

The various GRIP definitions contained in subsections 89(4) to and inclusive 89(7)

and the LRIP definitions contained in subsections 89(8) to and including 89(10) are sufficiently

complex for a separate paper.

For a dividend to be an eligible dividend, subsection 89(14) requires that the corporate payer

designate the amount to its shareholders. Designation occurs by notifying the dividend recipients

at the time of designation. CRA will consider that a public corporation has made a designation

where it publicly states on its website reports to shareholders or in a public release that all

dividends paid are eligible dividends. All other corporations must provide notification by letter,

by referring to it on the cheque or by noting it in minutes where all shareholders are directors.

If the amount is not designated, it is not an eligible dividend and, therefore, the concept of

excessive eligible dividend designation15

and the penalty provisions contained in section 185.1

will become applicable.

The designation must be made in respect of the full dividend paid. If a portion of the dividend is

designated, it is an invalid designation. If a corporation is paying a dividend in an amount in

12

As corporate tax rates decline, the gross-up and tax credit decline and increase the tax payable on the

dividends. The gross-up reduces to 41% in 2011 and 38% thereafter. 13

The tax credit reduces to 13/23 in 2011 and 6/11 thereafter. 14

Subsection 89(1).

15

Definition in subsection 89(1).

- 8 -

excess of GRIP, it should consider paying one dividend equal to the amount it wishes to

designate and pay a second dividend for the balance.

Appendix D sets out the tax rates for eligible dividends and the tax rate for dividends that are not

eligible dividends. To explore whether integration has been achieved, below are calculations of

both the corporate tax on $100,000 of business income and the individual tax on the dividend

(the $100,000 less the corporate tax) where the lesser of the dividend or $69,000 (the increase to

GRIP in respect of the corporate income) designated as an eligible dividend in respect of the

provinces of Quebec, Ontario and Alberta.

EXAMPLE:

QUEBEC

Corporate tax $29,900

Individual tax 21,600

$51,500

Individual Maximum Marginal Tax Rate 48.2%

ONTARIO



$48,650

Individual Maximum Marginal Tax Rate 46.4%

ALBERTA



$39,780

Individual Maximum Marginal Tax Rate 39%

As the examples demonstrate, integration has not been fully achieved.

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Income Tax Distinctions - Individual and Corporation

There are a number of differences in the computation of income tax payable by an individual and

by a corporation. Three will be briefly examined here while the others will be reviewed under

the heading “Corporations”.

The first example is minimum tax. An individual is required to compute, pursuant to section

127.5, an alternate calculation of income tax. This is equal to 15% (23% for Quebec purposes),

before surtax, of the individual's adjusted taxable income less the basic exemption which is

currently $40,000 ($25,000 for Quebec purposes). If this minimum tax exceeds the actual

income tax payable by the individual in the taxation year, this greater income tax liability is due.

This minimum tax is payable only by individuals and not by corporations.

A second contrast is the tax liability under part XIV. This liability applies only to a corporation

carrying on business in Canada, other than a corporation that was a Canadian corporation

throughout the year.16

Individuals, including non-residents, who carry on a business in Canada

through a proprietorship, are not subject to this part XIV tax.

Lastly, certain provinces impose a capital tax on corporations only. Provincial capital tax rates

are set out in Appendix “C”.

16

Subsection 219(1). Part XIV makes no reference to an income tax liability on individuals. The income tax

liability is equal to 25% of a somewhat detailed calculation. Part XIV levies an income tax essentially on non-

resident corporations carrying on a business in Canada to compensate for the fact that a branch pays no dividends

which, when paid to a non-resident (by a Canadian resident corporation), are subject to withholding.

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PARTNERSHIPS

Introduction

Partnerships have existed for centuries.17

Their use as a business vehicle results, in part, because

taxation rules in Canada flow income or loss of a partnership through to its partners.18

A partnership can be a general partnership, a limited partnership or a limited liability partnership

(“LLP”). A general partnership provides that each partner is jointly and severally liable for the

obligations incurred by the partnership, exposing all of the assets of a general partner to the

business risks arising from the conduct of the partnership's affairs. A limited partnership, which

is created by statute, provides for two classes of partners: general partners who are jointly and

severally liable for the obligations of the partnership, and limited partners who are liable for the

obligations of the partnership only to the extent of their contributions to the limited partnership.19

A LLP also is created by statute and applies to partnerships of professionals. Generally, personal

liability does not arise except if the partner is considered to have been involved in negligence

relating to a client’s activities.

It is the ability of partners to limit their liability through the creation of limited partnerships that

also has increased the utility of partnerships.20

17

For an excellent article, see Robert G. Witterick, Q.C., “The Partnership as a Modern Business Vehicle”, in

Report on Proceedings of the 41st Tax Conference, 1989 Conference Report (Toronto: Canadian Tax Foundation,

1989, 21:1-25).

18

Subsection 96(1).

19

See, for example, the Limited Partnerships Act, R.S.O. 1990, c. L.16, which is the legislation establishing

limited partnerships in the province of Ontario.

20

For a discussion of a comparison of the relative advantages and disadvantages of carrying on a business

through a partnership or through a corporation, see Douglas S. Ewens, “Partnerships and Corporations - A

Comparison of Related Advantages and Disadvantages”, Report of Proceedings of the 33rd Tax Conference, 1991

Conference Report (Toronto: Canadian Tax Foundation, 1982), 231-246.

- 11 -

Characteristics

A partnership commonly is defined as the relationship that subsists between persons carrying on

business in common with a view to profit.21

While partnership law differs from province to

province, there are three elements that are common to all partnerships:

(a) The parties must carry on a business in common. It is suggested in Lindley on the

Law of Partnership that the definition of business would include “virtually any

commercial activity or adventure”.22

(b) A partnership must involve more than one person. While a person generally does

not include a partnership, each of the Limited Partnership Act (Ontario),23

and the

British Columbia Partnership Act,24

for example, permit a partnership to be a

member of another partnership. Since a constituent element of a partnership is that a

business be carried on, if a partnership's sole activity is holding an interest in another

partnership, can it be said to be carrying on a business?

(c) The final requirement is that the parties carry on the business with a view to profit.

Profit is considered by the jurisprudence to be net profit.25

The income tax rules applicable to the taxation of a partnership and its partners differ from rules

which apply to persons acting either as co-owners or as joint venturers. Parties who wish to

associate as joint venturers or co-owners but not as partners must ensure that their relationship

21

See, for example, the Partnerships Act, R.S.O. 1990, c. P.5, section 2. See also Spire Freezers Ltd. v. The

Queen 2001 DTC 5158 (SCC), and Backman v. The Queen 2001 DTC 5149 (SCC) where the court looked at

whether a partnership, in fact, arises in the context of profitability. The Supreme Court held that once the elements

of partnership are met, the reason why the partnership was created will not result in its validity being overturned.

22

Ernest H. Scamell and R.C. L'Anson Banks, Lindley on the Law of Partnership, 15th Ed., London: Sweet

& Maxwell, 1984, 11.

23

Supra, note 16. The definition of person in section 1 includes a partnership.

24

RSBC 1979, c. 312. A person is defined in the Interpretation Act to include a partnership.

25

Re: Spanish Prospecting Company, Limited, (1911) 1 Ch. 92, at 99 (CA).

- 12 -

does not create a partnership. The mere statement that the parties are not a partnership should

not be considered sufficient to avoid the relationship being characterized as a partnership if the

principal three elements are met. Canadian jurisprudence has accepted that a joint venture may

be a distinct legal relationship that is different from a partnership. There is, however,

jurisprudence that supports the view that a joint venture is merely a form of partnership.26

The Canada Revenue Agency (“CRA”) has stated that it respects provincial law as to whether or

not a partnership exists.27

CRA traditionally has been prepared to accept the holding of real

estate as a joint venture or co-ownership, whether or not the relationship might be characterized

as a partnership. It may be unwilling to administratively accept a joint venture as not a

partnership where the purpose of avoiding characterization as a partnership is to obtain income

tax benefits for the investors.

To ensure that a joint venture is not a partnership the joint venture should be confined to a single

project or at least have a limited duration. In addition, each joint venturer should have separate

tasks to complete within the project, providing separate manpower and assets to complete such

tasks. Joint venturers should be precluded from acting as agents for others and the agreement

clearly should indicate that the parties are not partners. In my view, as the number of parties to a

venture increase, it is more likely that the joint venture would constitute a partnership since the

greater number of parties, the less involvement and the greater likelihood that the parties merely

are sharing profits. In a true joint venture, in my view, each party's share of profits of the joint

venture is dependent upon its activities and the manner in which each conducts its share of the

joint venture activities.

26

For an analysis of the distinctions between a partnership and joint venture, see, for example, David A.G.

Birnie, “Partnership, Syndicate and Joint Venture: What's the Difference?” in Report of the Proceedings of the 33rd

Tax Conference, supra note 17, at 182-195. The author summarizes some of the jurisprudence pertaining to

whether a joint venture can exist separately from the concept of a partnership.

27

Interpretation Bulletin IT-90 at paragraph 2.

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Computation of Income

A partnership computes its income as if it were a separate person resident in Canada and as if its

taxation year were its fiscal period.28

While the partnership does not file an income tax return

and is not a tax paying person, it generally is required to file an annual partnership information

return as is prescribed in the Act.29

Each partnership activity is considered to be carried on by the partnership as if it were a separate

person, with a computation being made for each taxable capital gain and allowable capital loss.30

The income of the partnership from a source or from sources for each taxation year is considered

that of the partners, thereby providing a flow-through of the income characteristic to each

partner.31

Thus, a partner carries on a business if the partnership carries on a business, even if

the partner is a limited partner. This is relevant because a partner will be considered to carry on

the business in each province where the partnership has an establishment. Furthermore, if the

partnership carries on a business in Canada, non-resident partners also will be considered to be

carrying on a business in Canada.

The calculation of income or loss of the partnership is computed generally without reference to

resource income or expenses.32

Capital cost allowance, however, must be claimed at the level of

the partnership.

One distinction in the tax treatment of a partnership and other entities is that scientific research

and experimental development expenditures incurred by the partnership must be deducted

annually in calculating partnership income and may not be carried forward as generally

28

Paragraphs 96(1)(a) and (b).

29

Regulation 229 to the Act.

30

Paragraph 96(1)(c).

31

Paragraph 96(1)(f).

32

Paragraph 96(1)(d).

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permitted.33

This obligation may affect a taxpayer's loss carry-forward position and may result

in taxpayers losing a portion of their loss carry-forwards. In addition, losses with respect to

scientific research and experimental development are restricted to members of partnerships who

(i) are not limited partners, and (ii) who are actively engaged in the activities of the partnership

and carry on a business similar to that carried on by the partnership on a regular and continuous

basis throughout the year.34

Flow-Through of Income or Losses

One of the advantages of operating a business through a partnership is that losses of the

partnership flow to the partners directly. This is beneficial where losses arise for income tax

purposes, for example, from capital cost allowance, scientific research and experimental

development expenses or significant start-up costs. In particular where the partners otherwise are

profitable entities who can use the partnership losses to offset income from other sources.

The advantage to a business incurring start-up costs which create a loss for income tax purposes

being conducted through a partnership can be seen in the following example. Assume that two

individual partners have substantial employment and/or investment income, and that their

maximum marginal income tax rate is 50%. Assume, further, that the partnership of which they

are equal partners incurs a $200,000 loss in its fiscal period. Since the loss is allocated to the

partners, each partner can deduct in computing income its share of partnership losses of $100,000

reducing their respective income tax liability by its tax rate. Contrast this with the situation where

the identical business is operated by a corporation. Although the corporation would have the

identical loss, it would be unable to use the loss until it realized income. Shareholders cannot

access the loss. While the corporation eventually might use the losses to reduce taxable income in

a subsequent year, the benefit of reducing an immediate income tax liability does not arise.

33

Paragraph 96(1)(e.1). Subsection 37(1) permits a taxpayer to deduct in computing income in a taxation

year scientific research and experimental development expenditures incurred in the year or preceding years to the

extent not otherwise deducted in a preceding year.

34

Paragraph 96(1)(g) and the definition of specified member in subsection 248(1).

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A number of flow-through issues arise where a business is conducted by a partnership. These

include:

(a) The partnership must deduct scientific research and experimental development

expenditure costs on an annual basis. Losses resulting from such expenditures do

not flow-through to all partners.

(b) Interest and property taxes generally may not be deducted in computing income

where they relate to land, except where the land is used in the course of a business

carried on by the taxpayer other than a business of resale or development.35

A

corporation whose principal business is the leasing, rental or sale, or the

development for lease, rental or sale, of real property is entitled to deduct interest,

computed at a prescribed rate, in respect of a loan of $1 million. This deduction is

not permitted to corporate members of a partnership although it would be permitted

to corporate members of a joint venture.

(c) A corporation whose shareholders include non-resident shareholders who do not deal

with each other at arm's length and who hold shares that represent more than 25% of

the votes or value of the shares of the corporation may be precluded from deducting

in computing income all of the interest payable on debts to such shareholders unless

the corporation maintains a certain debt to capital ratio.36

Non-residents who reside

in tax jurisdictions with lower income tax rates than Canada and who control a

Canadian resident corporation may try to minimize the income of its Canadian

subsidiary. One mechanism would be to fund the corporation with a maximum

amount of debt. These thin capitalization rules restrict the interest deduction to the

corporation if its debt to such non-residents exceeds two times a computation of

capital.

35

Subsection 18(2).

36

Subsection 18(4). This is commonly referred to as the "thin capitalization rules".

- 16 -

These rules may be avoided if the non-resident conducts the business in Canada

through a partnership. A loan made to the partnership would not be subject to the

thin capitalization rules, a position acknowledged by CRA.37

Thus, a partnership can

be capitalized with 100% debt. CRA may wish to review the transaction in light of

the general anti-avoidance rules (“GAAR”) to determine if the structure is governed

by GAAR.38

(d) Investment tax credits earned by a partnership flow-through to partners in proportion

to their partnership interest.39

The allocation of investment tax credits must be

considered reasonable with respect to the taxpayer's partnership interest.

(e) A person who is a "limited partner" of a partnership may be precluded from

deducting in computing income 100% of its partnership loss by application of the

limited partnership loss rules contained in subsection 96(2.1) and following. A

limited partner is defined in subsection 96(2.4) to include not only a partner who is a

limited partner under partnership law but a partner who receives or is entitled to

receive any amount or benefit which is granted for the purpose of reducing the

impact of any loss that the taxpayer may sustain by being a partner. The amount of

losses to which a limited partner would be entitled to deduct in computing income

are restricted to the taxpayer's “at-risk amount” less certain amounts relating to

investment tax credits and resource expenses. The at-risk amount is defined in

subsection 96(2.2) to include the taxpayer's adjusted cost base in the partnership and

is reduced principally by the amount of any benefit.

37

Revenue Canada Round Table, in Report of Proceedings of the 50th Tax Conference, 1998 Conference Report

(Toronto: CTF, 1999) 52:1-32 Question 1 at 52:14 updating a similar position taken at the 1992 annual conference, this

notwithstanding the contrary position of the Ontario General Division in Wildenberg Holdings Limited v. MNR, 98 DTC

6462. CRA did indicate that it would follow the Ontario decision in situations where a partner's role was contractually

limited.

38

The 2000 Federal Budget papers indicated that consultations would be initiated on the extension of the then

capitalization rules to this kind of arrangement. To-date, there have been no further developments.

39

Subsection 127(8). Note that subsection 127(8) applies to partnerships generally. Subsections 127(8.1)

through (8.5) apply to determine the investment tax credits available to a limited partner of a partnership. Investment

tax credits are subject to the at-risk amount of the partners and may not be fully attributable to a limited partner.

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Partnership Year-End

The definition of fiscal period requires that a partnership taxation year end on December 31 if in

a particular fiscal period a member of the partnership includes

(a) an individual (other than a testamentary trust or individual exempt from tax),

(b) a "professional corporation". A professional corporation is defined in subsection

248(1) to mean a corporation that carries on the professional practice of an

accountant, dentist, lawyer, doctor, veterinarian or chiropractor, or

(c) a partnership which includes such an individual or professional corporation. This

same provision requires a professional corporation to end its fiscal period on

December 31 if it is a member of a partnership that is required to end its fiscal period

on December 31. Thus, a professional corporation that is not a member of any such

partnerships can end its fiscal period at any time in the calendar year.

Partnerships which carry on a business outside Canada, or carry on a prescribed business (none

are prescribed to date) can adopt a fiscal period which ends other than on December 31 even if

an individual, professional corporation or partnership is a member during the fiscal period.

Since not all partnerships are subject to the requirement to adopt December 31 as the end of the

fiscal period, there are a number of observations and comments:

(a) The fiscal period of a law, accounting or engineering partnership consisting of

individuals must end on December 31. A law or accounting partnership consisting

of professional corporations also must adopt a December 31 fiscal period end.

However, an engineering partnership consisting of corporations can adopt a fiscal

period which terminates at any time, since a professional corporation does not

include the carrying on of an engineering or architectural practice.

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(b) A partnership owning real estate must adopt a December 31 year-end if, at any time

in the year, an individual is a partner, irrespective of the percentage ownership of

partnership interest. If, during the fiscal period, the individual's interest is purchased,

the end of the fiscal period following can be other than on December 31 although,

pursuant to subsection 249.1(7), consent of the Minister is required.

(c) If a partnership whose partners include an individual owns a rental property outside

of Canada, can its fiscal period end other than on December 31? The rules do not

require a partnership the business of which is carried on outside of Canada to adopt a

fiscal December 31 year-end. However, does the ownership of rental property by a

partnership constitute a business automatically (remember a partnership must carry

on a business to exist)? Jurisprudence suggests that almost any activity of a

corporation constitutes the carrying on of a business.40

Should this concept also

extend to a partnership based on the requirement that it carry on a business.

(d) A partnership consisting of corporate entities (other than professional corporations)

still is entitled to end its fiscal period on any day in the calendar year.

40

Canada Trustco Mortgage Corporation v. MNR, 91 DTC 1313 (T.C.C.). See also The Queen v. M.R.T.

Investments Ltd., 76 DTC 6158 (F.C.A.).

- 19 -

Avoidance Rules

The Act contains rules that apply if members of a partnership agree to share any income or loss

or any amount that is relevant in the computation of the income or taxable income of the

members, and the principal reason for the agreement is to reduce or postpone tax that would

otherwise be payable under the Act. In such a case, the share of each member in the income or

loss or the amount, as the case may be, will be adjusted to be reasonable having regard to all

circumstances including the proportions in which members agree to share profits or losses of the

partnership. The purpose of the first provision, subsection 103(1), for example is to preclude

partnerships which include non-taxable entities from allocating capital cost allowance and other

deductions to taxable entities since the non-taxable entities do not need such deductions.

Furthermore, two or more members of a partnership not dealing at arm's length with each other

must share income in a manner that is reasonable in the circumstances having regard to the

capital invested in or the work performed for the partnership by the members as required by

subsection 103(1.1).

Partners whose adjusted cost base becomes a “negative amount” generally are not subject to

income tax on this amount.41

This provision will not apply to the negative adjusted cost base of

"limited partners". Subsection 40(3.1) deems this negative amount to be a capital gain in the

year.

Generally, taxpayers may not create a loss or increase a loss by claiming capital cost allowance

in respect of either rental property42

or leasing property.43

A rental property is defined in

Regulation 1100(14) to mean a building or leasehold interest in real property which is used

principally for the purpose of gaining or producing gross revenue that is rent. Leasing property

essentially includes depreciable property, except rental property, where the principal use is to

41

Subsection 40(3). The rule which deems a gain to arise where there is a “negative” adjusted cost base is

not applicable to partnerships generally.

42

Regulation 1100(11).

43


- 20 -

obtain gross revenue that is a rent, royalty or leasing revenue.44

The rules in each instance do not

apply to certain corporations and to partnerships all of whose members are such qualifying

corporations.45

Corporations that are not required to restrict their capital cost allowance claims

in respect of rental property or leasing property must ensure that, in entering into a partnership

relationship, all other partners meet the same tests.

Small Business Deduction

Rules preclude the multiplication of the small business deduction through the use of corporate

partnerships.46

In computing the amount in respect of which a CCPC is eligible to claim the

small business deduction, the provision permits the inclusion of the “specified partnership

income” of the corporation. This requires a proration of income eligible for the small business

deduction amongst the partners proportionate to their partnership interest. Thus, if there are two

equal partners, each corporate partner would include a maximum of $250,000 in its computation

of income eligible for the small business deduction.

A corporation that is a member of a partnership controlled, directly or indirectly in any manner

whatever, by one or more non-resident persons, one or more public corporations (other than a

prescribed venture capital corporation) or by a combination thereof is precluded from including

in computing income eligible for the small business deduction any share of income from that

partnership. Subsection 125(6.2) deems specified partnership income of a corporation to be nil in

such circumstances. Control for these purposes is determined by the percentage of income.47

A

partnership is deemed controlled by a person or persons whose share of income exceeds 50% of

partnership income for the year. This precludes a CCPC which would be a minority shareholder

of a corporation that would not have qualified as a CCPC from structuring the business vehicle

as a partnership to obtain benefits of the small business deduction.

44


45

Regulations 1100(12) and 1100(16) respectively.

46

Subsection 125(1) and the reference to specified partnership income.

47

Subsection 125(6.3).

- 21 -

Where a corporation which has claimed the maximum small business deduction wishes to enter

into a new business in which it would be the majority holder, consideration might be given to

using a partnership to carry on the business in contrast to a corporation. This would entitle the

minority partner to obtain the benefit of the small business deduction with respect to its share of

specified partnership income. Consider the following example: ACO which already earns more

than $500,000 of active business income in a year will become a 60% holder of a new business

with BCO which will hold the remaining 40% and will have no other active business income. It

is expected that the new business will earn $500,000 per annum. If the business were to be

incorporated,

60 40

ACO would be associated with Newco48

and Newco would not be entitled to any further small

business deduction. Contrast this with the establishment of a partnership to hold the business

interest.

48

Paragraph 256(1)(a) deems one corporation to be associated with another if it is controlled, directly or

indirectly, in any manner whatever, by the other. Furthermore, one corporation is deemed to control another by

virtue of paragraph 256(1.2)(c) if one corporation holds more than 50% of the fair market value of all of the issued

and outstanding common shares of the other corporation.

ACO

BCO

NEWCO

- 22 -

60 40

Although ACO would not be able to increase its utilisation of the small business deduction,

BCO's specified partnership income would be $200,000 (40% of $500,000) and it would be

entitled to the small business deduction.

Provincial Allocation of Income

Persons who are a member of a partnership are considered to have a permanent establishment in

each jurisdiction in which the partnership has a permanent establishment.49

Each partner of a

partnership which has a permanent establishment in a province is required to allocate income to

each such province, to file income tax returns with those provinces where returns are necessary50

and to allocate in respect of its federal income tax return income to the other provinces and

territories pursuant to the allocation therein.

Income is allocated to a province by multiplying 50% of the aggregate of (i) gross revenue

attributable to each permanent establishment in a province, and (ii) salaries and wages

attributable to the permanent establishment in each province.51

The following illustrates this

procedure. Assume:

49

See No. 60 v. MNR (T.A.B.), 59 DTC 300.

50

These include the provinces of Quebec, Alberta and British Columbia for corporations and Quebec for

individuals.

51

Regulation 402 to the Act, and part IV of the Regulations.

ACO

BCO

PARTNERSHIP

- 23 -

(a) the partnership's taxable income is $1 million,

(b) gross revenue is $10 million, $4 million attributable to province No. 1 and $6 million

attributable to province No. 2,

(c) aggregate salary and wages is $6 million, $3 million attributable to each province.

Taxable income attributed to province No. 1 will be equal to

50% X ($ 4,000,000 + $ 3,000,000)

($10,000,000 $ 6,000,000),

or

X 50% (40% + 50%), or 45%

or

$450,000 of $1,000,000

The calculation of a corporation's gross revenue, and salaries and wages paid in the year includes

its share of partnership gross revenue, and partnership salaries and wages paid, proportionate to

its share of the income or loss of the partnership.52

Partnership Property Transfers

Similar to corporations, it is possible to transfer property to a partnership without incurring any

income tax liability by utilising the election provisions contained in sections 97 and 98. There

are a number of distinctions with regard to the rules pertaining to the tax-free transfer of assets to

a corporation and to a partnership, some of which are summarized below:

52

Regulation 406. Most provinces follow the federal computation in determining taxable income earned in a

province. See, for example, section 6(3) of the Income Tax Act (Saskatchewan), RSS 1978, c. I-2, as amended. The

provinces of Ontario and Quebec calculate taxable income earned in a province in accordance with their respective tax

legislations although the calculation is substantially identical to that contained in the Act.

- 24 -

(a) A tax-free transfer of an interest in real property that is inventory may not be

transferred to a corporation under subsection 85(1) since such property is not

“eligible property”.53

Real estate inventory may be transferred to a Canadian

partnership since all forms of inventory may be transferred tax-free to a

partnership.54

CRA has indicated, however, that where parties elect to transfer real

estate inventory to a partnership with a view to ultimately transferring that inventory

to a corporation, it may elect to use the GAAR provision to attack such a

transaction.55

(b) Tax-free transfers are permitted to all taxable Canadian corporations including those

controlled by non-residents. Transfers to a partnership must be to a “Canadian

partnership”, defined in subsection 102(1) to mean a partnership all of the members

of which were resident in Canada at the time. In contemplating the establishment of

a new business with one or more non-resident persons, consideration must be given

to the potential taxation of accrued gains on properties which would be transferred to

that new business vehicle if it is a partnership. It may be necessary to structure the

timing of admission of non-resident partners. If non-residents are to be partners,

they should join after the transfer of property. A transfer is eligible for rollover

treatment if, immediately after the transfer, the partnership is a Canadian partnership.

(c) Where a corporation wishes to distribute property to one or more or all of its

shareholders, it must abide by the “butterfly” provisions of section 55.

The rules pertaining to the transfer of property by a partnership to its partners are in

some ways simpler and in some ways more complex than the butterfly provisions

applicable to a corporation.

53

See the definition of eligible property in subsection 85(2.1) which excludes real estate inventory.

54

Subsection 97(2).

55

Information Circular IC 88-2, paragraph 12.

- 25 -

(i) In the first instance, each partnership property must be distributed in

undivided interest to each partner, proportionate to its interest in the

partnership.56

In a butterfly transaction, a shareholder may receive one

property and not another property provided that the proportionality tests

set out in paragraph 55(3)(b) are met.

(ii) All taxable Canadian corporations may undertake butterfly

transactions. Only Canadian partnerships may make tax-free

distributions. Partnerships with non-resident shareholders, therefore,

may not avail themselves of the provisions of subsection 98(3).

(iii) Section 55 effectively precludes dispositions that are part of the series

of transactions that include the butterfly. Subsection 98(3) contains no

such restrictions.

Partnership Estate Freeze

Unlike a corporation, using a partnership as an estate freeze vehicle may not be effective where

the freeze is in respect of an existing business. Assume a parent holds an interest in a

corporation. The estate freeze can be accomplished through a corporate structure by creating a

new corporation (“Newco”), by causing the parent to transfer the shares of the target corporation

to Newco in exchange for preferred shares and by issuing common shares of Newco to the

children or a trust created for their benefit. No obligation exists to pay dividends to the parent in

respect of the preferred shares issued.

If a partnership was used for an estate freeze to avoid a capital tax liability which would

otherwise arise in using a corporation, the partnership would issue to the parent, in exchange for

the asset transferred, a non-participating interest in the partnership. It would be open to CRA to

challenge the failure to allocate income to the parent in respect of its interest pursuant to


56

Subsection 98(3).

- 26 -

Flow-Through Issues

CRA appears to have an occasional inconsistent treatment when it comes to the flow-through of

certain taxation elements to partners.

(a) CRA is of view that the term "taxpayer" applies to a partnership when that term is

relevant to the computation of income, since paragraph 96(1)(a) requires the

partnership to compute income as if it were a separate person resident in Canada.

This view does not necessarily extend to the use of the word "taxpayer" in respect of

income tax credits and the levying of income tax.

(b) Paragraph 96(1)(f) deems a source of income of the partnership to be that of the

partners. Partners of a partnership which receive taxable dividends and capital

dividends are considered to have received their respective share.57

(c) For the purposes of determining part IV tax, subsection 186(6) deems taxable

dividends received by a partnership to be received by each member of the

partnership and deems each member of the partnership to own shares of the

corporate payer proportionate to its share of dividends received from the partnership.

But for this provision, presumably a corporate payer of dividends would not be

connected with a corporate partner of a partnership that received dividends.

The technical notes indicated that this amendment to the Act simply was for

clarification. CRA’s administrative position at the time was identical to this

amendment. This position implied that each corporate partner of a partnership

owned shares of any corporation held by the partnership proportionate to its interest

therein.

57

Interpretation Bulletin IT-138R, paragraphs 4 and 5.

- 27 -

(d) Subsection 112(1) permits a corporation to deduct in computing taxable income

taxable dividends received from taxable Canadian corporations. CRA acknowledges

that this provision applies in respect of dividends received by a partnership and

allocated to corporate partners. The distinction between subsections 112(1) and

113(1) upon which CRA had relied is the reference to the word “received” in

subsection 112(1) in contrast to the word “owned” in subsection 113(1). It should be

noted, however, that section 96 only deals with the computation of income and not

the computation of taxable income and that this cannot be the basis for CRA's

position.

(e) Subsection 112(3) exists to preclude corporations from claiming capital losses in

certain circumstances where the corporation has received various dividends in

respect of a share. The provision applies with respect to corporate ownership of

shares. Subsections 112(3.1) and (3.2) were added to ensure identical rules applied

to a corporate member of a partnership or to a beneficiary of the trust. Presumably,

the Department of Finance felt the need to introduce these provisions because it had

concluded that a corporate partner would not be considered to own shares of a

corporation held by the partnership.

(f) CRA is of the view that an interest in a partnership is not considered an interest in its

underlying assets for the purposes of section 85. Nevertheless, for the purposes of

determining whether or not a corporation is a “small business corporation”, CRA

considers that the corporation may look at the underlying partnership assets to

determine whether or not it meets the tests.

(g) CRA is of the opinion that where a business is carried on by a partnership, each

partner is considered to employ the employees of the partnership. This is important,

for example, in determining whether or not a corporation has or has no income from

a specified investment business.

- 28 -

JOINT VENTURES OR SYNDICATIONS

Introduction

The taxation of persons who have an interest in a joint venture or syndication can differ from the

taxation of partners of a partnership. The reference here to a joint venture or syndication is a

reference to a business vehicle that would not be considered a partnership for purposes of

partnership law. Because of these differences, practitioners have to be able to distinguish

between when a business vehicle is or is not a partnership.

In order not to be a partnership, it is necessary that not all the constituent elements of a

partnership exist. In particular, it would have to be found, in my view, that the parties are not

carrying on a business in common or that they are sharing gross revenues and not profits. If an

agreement between the parties conducting the business specifies that the business vehicle is not a

partnership, that should not be sufficient to characterize the business vehicle as not being a

partnership if the constituent elements of partnership otherwise are met. In Woodland

Developments v. MNR,58

the parties entered into an agreement which indicated that they were

partners. The Tax Court in this instance indicated that reference in an agreement to the words

partner or partnership were not necessarily conclusive of the arrangement and that one had to

look at all of the elements of the agreement.

It is of interest to note that CRA is prepared to permit a joint venture that is not a partnership to

select a fiscal year-end59

which may differ from that of the joint venturers provided that all

participants are in agreement. This position applies where the participants have different fiscal

periods or where they have the same fiscal periods but business reasons justify a separate year-

end. CRA also takes the position that once the property of the joint venture is disposed, the

fiscal period ends at that time.

58

86 DTC 1116 (TCC).

59

“Revenue Canada Round Table”, in Report of Proceedings of the 41st Tax Conference, 1989 Conference

Report (Toronto: Canadian Tax Foundation, 1990), 45:1-60, question 40, at 45:23-24. See also Revenue Canada

letter 9335915 dated April 28, 1994.

- 29 -

One of the pitfalls involved in attempting to establish a business vehicle as a joint venture and

not a partnership pertains to assets used in the business. Where the entity is a proper joint

venture, each joint venturer does not transfer any assets to the joint venture but uses them to

conduct its share of the joint venture activities. No rollover, therefore, is needed because there is

no disposition. If the business vehicle in fact is a partnership and if the assets would be the

assets of the partnership, each partner would have been considered to have disposed of its assets

to the partnership. Although rollover provisions are available for a partnership, by not properly

characterizing the vehicle as a partnership, the rollover forms would not have been filed and a

disposition at fair market value will occur unless a late filed election is filed.

Distinctions between a Partnership and a Joint Venture

Income tax benefits that result from being characterized as a joint venture and not a partnership

include the following:

(a) A non-resident who is a member of a partnership that is carrying on business in

Canada also is considered to be carrying on business in Canada.60

If the structure is

a joint venture, the activities of a non-resident joint venturer will be considered to be

carried on in Canada solely dependent on its activities.

(b) Where a business vehicle is a partnership that is not a Canadian partnership, the

partnership is deemed to be non-resident person in respect of amounts that are

subject to part XIII withholding.61

Thus, if a partnership has one non-resident

partner, all payments received by the partnership would be subject to such

withholding in their entirety and not solely the amount attributable to the non-

resident partner. Tax credits would be permitted in respect of the Canadian partners.

Regulation 805 eliminates the withholding if the partnership carries on business in

Canada. Where a non-resident is a member of the joint venture, these rules are not

applicable.

60

Les Entreprises Blaton-Ubert Société Anonyme v. MNR, 73 DTC 5009 (FCTD).

61

Subsection 212(13.1).

- 30 -

(c) Partnership expenses, including capital cost allowance and scientific research are

claimed at the partnership level, except for those relating to resources expenditures.

Where not all partners are in agreement as to how these expenses should be deducted

in computing income, this may be disadvantageous to certain partners. Where the

business vehicle is a joint venture, each joint venturer claims capital cost allowance

and scientific research expenditures on its own and has greater flexibility with regard

to their treatment.

(d) Where a partnership owns depreciable property and the fiscal year of the partnership

is less than 365 days, capital cost allowance must be prorated by the number of days

of the fiscal year in relation to 365,62

even if a partner's fiscal year is 365 days. If the

persons carrying on the business conducted the business as a joint venture, this

restriction in capital cost allowance would not apply since each joint venturer would

be considered to own its share of the property directly.

(e) As mentioned previously, the Act contains rules which restrict the amount of active

business income earned by a partnership that is allocable amongst its corporate

partners for purposes of the small business deduction. These rules do not apply in

respect of a joint venture. Where a business venture realizes $1,200,000 of active

business income, and there are two equal (non-associated) joint venturers, each

would be entitled to include $500,000 of active business income in its calculation of

the amount eligible for the small business deduction.

(f) For losses in respect of rental property and leasing property to be created or

increased by claiming capital cost allowance requires, in respect of a partnership,

that each partner meets prescribed tests. Where not all of the partners would qualify,

it would be preferable to structure the activities as a joint venture and not as a

62

Regulation 1100(3).

- 31 -

partnership thereby entitling those qualifying corporations to maximize their

deductions and losses.

CORPORATIONS

Income Tax Payable

While an individual's marginal income tax rates do not differ dependent upon the type of income,

a “Canadian-controlled private corporation” is entitled to deduct in computing part I tax 18% of

its income from an active business carried on in Canada, to a maximum of $500,000.63

Special

rules exist that limit the maximum deduction permitted in respect of corporations associated with

each other64

and in respect of active business income derived through a partnership.65

Furthermore, the small business deduction is reduced once the corporation's "large corporations

tax" (calculated without reference to the investment allowance) exceeds $11,250 pursuant to


There is a second deduction from tax accorded to all corporations, but not to income on which

the small business deduction has been claimed. Subsection 123.4 essentially permits a

corporation to deduct from tax otherwise payable66

10% of said profits (except for profits from

investment income earned by a Canadian-controlled private corporation). The manufacturing

and processing credit in section 125 is tied to this rate. Subsection 125.1(2) provides for an

equivalent deduction for a corporation that generates electrical energy for sale, or produces steam

for sale. Again, this deduction does not apply to the calculation of part I tax of an individual.

63

Subsections 125(1) and (2).

64

Subsection 125(3). Associated corporations must share the $500,000 business limit between them. Some

provinces provide for a small business deduction that exceeds $500,000.

65

As indicated previously, a corporation that is a member of a partnership is only entitled to include in the

calculation of active business income eligible for the small business deduction the “specified partnership income” of

the corporation, subparagraph 125(1)(a)(ii).

66

The rate increases to 11.5% in 2011 and 13% thereafter.

- 32 -

Investment tax credits are available to all eligible taxpayers who incur eligible expenditures. The

taxpayer is entitled to include a specified percentage of the expenditure in the computation of its

investment tax credit.67

Where the business incurs expenditures in respect of scientific research

and experimental development, and where the business is not expected to generate income for

the purposes of the Act, there are advantages available to a taxpayer that conducts its business as

a Canadian-controlled private corporation in contrast to the carrying on of the business as a

proprietorship. The general investment tax credit in respect of scientific research and

experimental development expenditures is 20% (30% if conducted in the Maritimes or the Gaspé

Peninsula). In respect of the first $3m of said expenditures incurred by a Canadian-controlled

private corporation (special rules apply to associated corporations), the investment tax credit rate

increases to 35% of such expenditures in a taxation year pursuant to subsection 127(10.1). No

equivalent increase in the percentage of investment tax credits is available for individuals.

While the inclusion of the percentage in investment tax credits differs between individuals and

corporations, it is interesting to note that there is no distinction between the percentage of

investment tax credits to which certain Canadian-controlled private corporations and individuals

may claim under section 127.1 as a refund of tax.68

There is a difference regarding the amount of capital cost allowance that may be claimed by

certain corporations and by individuals in respect of “rental property” or “leasing property”.

Regulation 1100(11) essentially precludes a taxpayer from increasing or claiming a loss by

claiming capital cost allowance in respect of a rental property. This provision, however, does not

apply to a taxpayer who was, throughout the year,

(a) a life insurance corporation, or a corporation whose principal business was the

leasing, rental, development or sale, or any combination thereof, of real property

owned by it, or

67

Subsection 127(5) and the definition of investment tax credit in subsection 127(9) which provide

application to all taxpayers.

68

Section 127.1 entitles taxpayers, who include qualifying corporations and individuals other than a trust, to

obtain a refund of its refundable investment tax credit.

- 33 -

(b) a partnership each member of which is a corporation described in (a) above.69

Said corporations are commonly referred to as “principal business corporations”.

An individual, however, even if the individual's principal business is identical to that of a

principal business corporation, is not entitled to the same benefit and may not claim or increase a

loss from rental property by claiming capital cost allowance.

Similar rules apply in respect of leasing properties. Regulation 1100(15) again precludes a

taxpayer from claiming or increasing a loss in respect of leasing property. These rules do not

apply to a taxpayer that was, throughout the year,

(a) a corporation whose principal business was the renting or leasing or leasing property,

or the renting of property combined with the selling or servicing of that property

provided that its gross revenue from such principal business was at least 90% of its

gross revenue for the year from all sources, or

(b) a partnership each member of which was such a corporation.70

LIMITED LIABILITY CORPORATION

A limited liability corporation ("LLC") is a corporation that for purposes of United States income

tax law may be treated as a pass through entity or a partnership with income or loss allocated to

the shareholders. Because of its tax status, a LLC is often used in cross-border investments.

Most states in the United States have enacted specific legislation to create a LLC. In Canada, the

provinces of Nova Scotia, Alberta and British Columbia have legislation that creates a

corporation that qualifies as a LLC for United States income tax purposes, the unlimited liability

69


70


- 34 -

corporation (“ULC”). A ULC can qualify as a LLC under the Internal Revenue Code “check-

the-box” rules. If a ULC elects, it is, for United States income tax purposes, a LLC.

A ULC is established in Nova Scotia in a manner similar to the incorporation of any other Nova

Scotia company. Like other corporations, share capital is issued. A shareholder of a ULC has

unlimited joint and several liability for the obligations of the company only upon its dissolution.

So long, therefore, as a ULC is not dissolved, the actual liability of the shareholders is deferred.

It should be noted that a ULC may register as a regular corporation. However, such registration

does not affect any debts or liabilities incurred prior to the registration.

CRA considers a LLC to be a corporation for the purposes of the Act. Thus, income realized by

a ULC or by a LLC created in the United States will be taxable at the level of the corporation and

not at the level of the shareholders. Distributions by a ULC will be treated as dividends with the

corresponding withholding tax obligations.

A LLC incorporated in the United States can be a “foreign affiliate” or “controlled foreign

affiliate” of its Canadian shareholder(s), depending on whether the percentage ownership tests

are met. While the United States will treat the income of a LLC as that of its partners, subjecting

the partners to a direct tax, Canada will only tax the Canadian shareholders of a LLC on

payments received therefrom either as dividends or interest, as the case may be. This distinction

in the income tax treatment of a LLC gave a Canadian corporation the ability to obtain income

tax benefits in financing a U.S. structure. Specifically, this structure allowed for the deductibility

of interest in respect of a loan made to a LLC both for Canadian and U.S. income tax purposes

(the “double dip”). To combat the double dip, paragraph 7 to Article IV (residence) denies treaty

protection in situations where an entity considered fiscally transparent in one jurisdiction is not

treated the same in the other.

If a LLC was considered a flow-through for U.S. income tax purposes, CRA took the position

that the LLC was not a resident of the United States for the purposes of the Canada-U.S. Income

Tax Convention (1980). Article IV defines a resident of the United States as a person who, under

its laws, is liable to tax therein by reason of that person's domicile, residence, citizenship, place

of management, place of incorporation or any similar criterion. Since the partners and not the

- 35 -

LLC are taxable in the United States, the LLC would not be considered a resident of the United

States. Thus payments to a LLC that is treated as a disregarded entity for U.S. income tax

purposes would have been subject to part XIII withholding of 25% and would not have obtained

the benefit of the reduced rates of the Convention. In addition, the Convention would not have

applied to capital gains taxable under the Act.

The 5th

Protocol to the Canada-U.S. Income Tax Convention eliminated this issue. The addition

of paragraph 6 to article IV provides for a look-through approach with regard to a LLC. If, under

U.S. income tax law, the shareholder/member of the LLC is considered to derive the revenue

earned by the LLC, the treaty will provide that it is the member/shareholder that is to be looked

at to determine the rate of withholding and the treaty benefits. As a result, residents of the

United States who are shareholders/members of a LLC benefit from the provisions of the

Canada-U.S. Income Tax Convention.

INCOME TAXATION OF TRUSTS

Introduction

Income of a trust is taxed only in one instance (subject to the rules pertaining to specified income

fund trusts or SIFTs), either at the trust level or at the beneficiary level. An inter vivos trust, a

trust that is not a testamentary trust, is subject to federal income tax at a flat rate of 29% plus

provincial taxation generally at the highest rate. The Taxation Act (Quebec) also establishes a

flat rate of 24% for an inter vivos trust.71

A trust generally is entitled to deduct in computing income amounts that become “payable” in

the year to a beneficiary or are included in the beneficiary's income under subsection 105(2).72

The definition of payable in subsection 104(24) is defined in the negative such that an amount

shall be deemed not to have become payable in the year unless it was paid to the beneficiary in

the year or the beneficiary was entitled in the year to enforce payment of the amount. To avoid

71

Section 768 of the Taxation Act, R.S.Q. c. I-3.

72

Subsection 104(6).

- 36 -

the onerous income tax rate of an inter vivos trust, care should be taken to ensure that income

becomes payable in the year to a beneficiary in accordance with this subsection.

An inter vivos trust must adopt December 31 as its year end.73

Flow-Through

A trust provides for certain income to flow-through to its beneficiaries, but not others. By way

of examples,

(a) Taxable dividends received by the trust may be designated to be a taxable dividend

received by the beneficiary.74

(b) Taxable capital gains also may be designated as being taxable capital gains of a

beneficiary.75

(c) Foreign income taxes, including business-income tax and non-business-income tax,

are deemed to be paid by taxpayers who are beneficiaries of a trust.76

(d) Unlike a partnership, however, all categories of losses incurred by a trust cannot be

claimed by the beneficiaries against the beneficiary's income as there is no specific

provision which allows for such an allocation. Non-capital losses realized by a trust,

therefore, must be claimed by the trust in any of its three preceding or ten subsequent

taxation years. This creates an anomaly where the trust instrument requires that all

73

Subsection 249(1) provides that an individual's taxation year is its calendar year. A trust, pursuant to

subsection 104(2), is deemed to be in respect of the trust property an individual.

74

Subsection 104(19).

75

Subsection 104(21).

76

Subsection 104(22.1). The trust also may designate, pursuant to subsection 104(22), that foreign income is

deemed to be a particular beneficiary's income from that source, to the extent that the income can be reasonably

considered to have been included in the taxable income of that beneficiary, having regard to all circumstances.

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its income is payable to beneficiaries. In such a circumstance, it will not have income

and, therefore, no ability to offset loss carry forwards. In such a case, subsection

104(13.1) permits a trust to designate an amount not to have been paid or to have

become payable to a beneficiary. The trust would designate an amount equal to its

loss carry forwards (sufficient to reduce its income to nil) and the beneficiary,

accordingly, would not be subject to income tax on such income.

(e) Income derived by a trust is deemed to be income from property that is an interest in

the trust and not from another source.77

Thus, active business income realized by the

trust becomes income from property to the beneficiaries.

(f) An inter vivos trust will be deemed to have disposed of its property every 21 years.78

An inter vivos trust, unlike a corporation or partnership, must take steps within 21

years to distribute property with appreciated gains. The failure will result in a

premature income tax liability. “Mutual fund trusts” are not subject to this rule.

(g) One problem that arises with a trust owning shares of a private corporation is that

dividends received by the trust and allocated to a corporate beneficiary nevertheless

may be subject to part IV tax even if the trust holds more than 10% of the shares of

the corporation having votes and value. A corporation that pays a dividend may be

“connected” to a recipient corporation and, if so, part IV tax becomes payable by the

recipient corporation only to the extent that the dividend resulted in a dividend

refund to the corporate payer.79

A payer corporation is connected to another

corporation in one of two circumstances:

(i) if the recipient corporation owns more than 10% of the shares of the

payer corporation having votes and value; or

77

Subsection 108(5).

78

Subsection 104(5). Subsection 104(5.3) allows for the postponement of the day on which trust assets are

considered to be disposed until 1999.

79

Subsection 186(1).

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(ii) if the payer corporation is controlled by the recipient.80

Subsection

186(2) extends the concept of control to situations where a corporation

is part of a group of persons who do not deal at arm's length with each

other which own more than 50% of the full voting shares of the payer.

If the trust of which the corporation is a beneficiary is part of a group that controls

the payer corporation, then part IV tax is payable only to the extent of dividend

refunds. If not, then the payer corporation is not connected to the corporate

beneficiary since the latter owns no shares in the corporation. Subsection 104(19),

which deems a beneficiary to receive a taxable dividend on shares of a corporation

held by the trust, does not deem the beneficiary to own the shares. Section 186 only

flows-through the ownership concept to partnerships.

(h) Where a trust, other than a testamentary or mutual fund trust, has a non-resident

beneficiary (including a trust or partnership with a non-resident beneficiary or

partner), the utilisation of the trust to hold investment property may result in a

special income tax.81

Part XII.2 obliges such a trust to pay a tax equal to 36% of the

least of three amounts including its “designated income” for the year.82

This term is

defined in subsection 210.2(2) to include all taxable capital gains from the

dispositions of real property situated in Canada and businesses carried on in Canada,

and not just to the amount attributable to the non-resident. The income tax paid by

the trust can be designated by the trust and be deemed paid by all of the

beneficiaries, thereby resulting in a tax credit to such beneficiaries.83

This income

tax cost is greater than the federal income tax payable by any beneficiary.

80

Subsection 186(4).

81

Section 210.1 provides that part XII.2 tax is not applicable to testamentary trusts and mutual fund trusts, for

example.

82

Subsection 210.2(1).

83

Subsection 210.2(3). Subsection 210.2(4) flows through the credit to partners of a partnership.

- 39 -

Beneficiaries who are non-taxable entities, for example, a registered retirement

savings plan or registered pension plan also are subject to these rules.

(i) Investment tax credits earned by a trust generally may not flow-through to

beneficiaries. Subsection 127(7) provides for an exception in the case of such a

flow-through to beneficiaries of testamentary trusts and inter vivos trusts of very

restricted organizations. A business that earns such investment tax credits carried on

by a trust would be lost.

(j) Trusts that earn Canadian manufacturing and processing profits may not be entitled

to flow the tax credit to their beneficiaries. Income earned by the trust is deemed to

be income from property pursuant to subsection 108(5). In any event, Regulation

5200 does not flow-through to a trust its share of the elements necessary to calculate

manufacturing and processing profits as Regulation 5204 does for a partnership.

(k) Similar to a partnership, capital cost allowance must be claimed at the level of the

trust and cannot be flowed-out to beneficiaries.

INCOME TRUSTS

Introduction

The traditional underlying asset base of an income trust or income fund are either assets in the

resource sector (a royalty trust) or in the real estate sector (a real estate investment trust or

REIT).

The income trust structure reduced income tax by eliminating wholly or substantially, the

corporate income tax payable on the business income. The result was that income that was taxed

at the corporate level and then at the individual level (being tax on the dividend of the net profit)

became taxable only at the investor/beneficiary level. In an example where if the corporate

marginal income tax rate was 31% and the individual’s rate of tax on dividends 31%, the

aggregate tax was 55% and the net receipt was 45%. When an income trust structure was

- 40 -

implemented, that same income resulted in the net receipt by that individual of 56% if resident in

BC, and 54% if resident in Ontario. And if the investor was a pension fund or RRSP, income tax

was eliminated entirely.

It did not take long for the income trust market to become an important feature in Canada’s

investment community, particularly since the value of the corporation could rise 20% - 30%

upon conversion into an income fund. And once legislation was enacted confirming that no

liability could attach to a beneficiary of a trust, pension funds began to invest significantly.

On October 31, 2006 in what was considered somewhat of a surprising announcement, the

Minister of Finance proposed to levy a tax on income trusts and partnerships (defined as a “SIFT

trusts” and a “SIFT partnerships” respectively) at a tax rate of 31.5 %. Implementation of the tax

is delayed until 2011 for all such trusts and partnerships which were publicly traded on or before

October 31, 200684

.

Legislation

The implementing rules are complex and should be the subject of an entire paper. In brief, a

SIFT trust;

(a) is a trust resident in Canada.

(b) Investments in a trust are listed or traded on a stock exchange or other public market.

(c) The trust holds one or more “non-portfolio properties”.

A non-portfolio property arises where;

(a) the trust or partnership holds more than 10% of the equity value of, or where it and

“affiliated entities” hold more than 50% of the equity value of, a trust, partnership or

84

To continue to qualify for the exemption, the Act limits the growth through the issuance of units.

- 41 -

corporation resident in Canada, or a non-resident person whose principal source of

income comes from Canada;85

(b) where more that 50% of the equity value of the trust of partnership consists of Canadian,

real, immovable or resource property any time in the year; or

(c) property is used by the trust or partnership, or person with whom such entity does not

deal at arm’s length, in the course of carrying on a business in Canada.

A trust generally is entitled to deduct in computing income any amount that became payable in

the year to a beneficiary.86

However, the SIFT trust is not entitled to a deduction in computing

its income in respect of income derived from non-portfolio property. Non-portfolio earnings,

also defined in section 122.1, are the income for the year from a business carried on by it in

Canada or from a non-portfolio property.

Let us assume that the income fund’s income for the year would be $90, that its distributions for

the year are $100, and that all of its income was generated from non-portfolio properties. But

for these rules, the income fund would be entitled to deduct in computing income $90, being the

income distributed.

The amount that is otherwise deductible under paragraph 104(6)(b) would be reduced by the

adjusted distribution amount (here $90). Thus the tax would apply to the $90. The other $10 of

distribution is not taxable.

The amount that is subject to the SIFT tax, the $90, also is deemed to be a dividend under

subsection 104(16).

The new tax does not apply to what is defined as a real estate investment trust (“REIT”). A

REIT is defined as a trust resident in Canada where;

85

Definitions in subsection 122(1).

86

Paragraph 104(6)(b).

- 42 -

(a) It does not hold any non-portfolio property other than “qualified REIT properties”;

(b) The aggregate income from such properties and taxable capital gains is not less than 95%

of its income for the year;

(c) At least 95% of its income for the year must be derived from rent from real or immovable

properties, interest, capital gains from such rental properties, dividends and royalties; and

(d) Total fair market value of all real or immovable property situated in Canada, cash and

certain government debt must be at least 75% of its equity value throughout the year.

The definition means that a REIT for these purposes cannot operate hotels or retirement complex

housing.

Characteristics

An income trust is a “mutual fund trust” which itself must be a “unit trust”. As a trust, the

income trust generally is taxable in the manner of other trusts which rules permit a trust to flow

through its revenue to the beneficiaries. The reasons for using a mutual fund trust to accomplish

this are the following:

(a) Certain trusts are deemed to dispose at fair market value certain assets every twenty-one

years pursuant to subsection 104(4). These rules do not apply to a mutual fund trust.

(b) Registered Retirement Savings Plans (RRSPs), Registered Retirement Income Funds

(RRIFs), Registered Pension Plans (RPPs) and Deferred Profit Sharing Plans (DPSPs)

often are buyers of income trusts. RRSPs, RRIFs and DPSPs are liable to pay tax to the

extent that the plan acquires or owns a non-qualified investment. A “qualified

investment” does not include a unit of a trust that is not a mutual fund trust and includes

- 43 -

partnership interests only in limited exceptions.87

A series of penalties arise where

certain of the above plans own a non-qualified investment under section 207.1 and

subsections 146(10) and (10.1) and subsections 146.3(7) and (9).

(c) Lastly, where a trust realizes certain sources of income and its beneficiaries include non-

resident persons, the trust is liable to pay a tax under Part XII.2. Exceptionally, the rules

do not apply to a mutual fund trust.

Unit Trust

In order to qualify as a mutual fund trust, the income trust must be a unit trust resident in

Canada. A unit trust is defined in subsection 108(2). The unit trust must be an inter vivos trust,

that is a trust other than a testamentary trust [a trust arising on the death of an individual as set

out in its definition of subsection 108(1)]. The interest of each beneficiary must be described by

reference to units of the trust. While the Act does not set out a definition to the term “unit”, a

unit generally refers to an undivided interest in the trust. Although it is possible to issue classes

of units whose percentage income interest in the trust differs from its percentage capital interest

in the trust, this may create adverse income tax consequences pursuant to subsection 104(7.1).

This provision stipulates that where it is reasonable to consider that one of the main purposes for

the existence of a term or other attribute of an interest in the trust is to give a beneficiary a

greater percentage in the property of the trust than its percentage interest in the income of the

trust, the deduction permitted under paragraph 104(6)(b) is denied. This deduction is crucial to

the operation of the income trust.

A unit trust also must satisfy one of the following two requirements:

(a) Not less than 95% of the fair market value of all issued units of the trust (determined

without regard to voting rights) include units having conditions attached that require the

trust to accept, at demand of the holder, that the units be redeemed at prices determined

and payable in accordance with the terms of the trust (the redemption requirement).

87

Definition of “qualified investment” in section 146(1), and regulations 4900 and 5000.

- 44 -

(b) The trust

(i) must be resident in Canada throughout the year.

(ii) Its only undertaking must be the investment of funds in property (except real

property), the acquisition, holding, maintaining, improving, leasing or managing

of real property or an interest therein that is capital property to it, or a

combination of the above.

(iii) Not less than 80% of its property must be shares, property convertible into shares,

cash, bonds and debentures, marketable securities, real estate or an interest in real

property situated in Canada, and rights to an interest in any rental or royalty in

respect of Canadian-based resources.

(iv) 95% of its income must be derived from, or from the disposition of, these

investments.

(v) Not more than 10% of its property may consist of bonds, securities or shares in

the capital stock of a corporation or debtor, other than the federal, provincial or

municipal government.

(vi) In the case of a REIT only, the units must be listed on a prescribed stock

exchange in Canada (the investment requirement).

Both the royalty trust and the REIT can be designed to meet the investment requirement. An

income trust that is neither a royalty trust nor REIT will not meet this investment requirement

except in unusual circumstances, and must comply with the redemption requirement to qualify as

a unit trust. CRA has issued rulings allowing the income fund to pay the redemption of units by

distribution of trust assets in lieu of cash.88

Furthermore, CRA permits the fund to redeem units

at a reasonable discount to the market price. Care must be taken to ensure a RPP for example

can receive an asset that is a qualified investment.

88

Advanced Income Tax Ruling document number 2001-0081903. CRA will permit the redemption price of units

in excess of a maximum amount per month to be satisfied by the distribution of assets owned of the income trust in

lieu of cash.

- 45 -

Mutual Fund Trust

A mutual fund trust must meet requirements relating to its activities, the number of beneficiaries

and that units “qualify for distribution to the public”. A further requirement of a mutual fund

trust is that, under its terms and conditions, it cannot have been established primarily for the

benefit of non-resident persons. In such circumstances, subsection 132(7) will deem the trust not

to be a mutual fund trust unless all or substantially all of its property is not taxable Canadian

property. The income fund prospectus and trust agreement will provide that no more than 49%

of the units can be held by non-resident persons and that the trust will have the right not to issue

units to, or permit the transfer of, units to non-residents in the event that this provision would be

breached.

APPENDIX "A"

2010

PERSONAL INCOME TAX RATES

PROVINCE MAXIMUM RATE

Alberta 39.0%

British Columbia 43.7%

Manitoba 46.4%

New Brunswick 43.3%

Newfoundland 44.5%

Nova Scotia 48.2%

Ontario 46.4%

Prince Edward Island 47.4%

Québec 48.2%

Saskatchewan 44.0%

(Rates include surtax if applicable)

APPENDIX "B"

2010

CORPORATE INCOME TAX RATES

A B C D

PROVINCE

Eligible For

Small Business

Deduction (SBD)

Mfg Income

Not Eligible

for SBD

CCCP non-

Manufacturing

Business

Income Not

Eligible for SBD

Investment

Income for

CCPC1

Alberta 14.0% 28.0% 28.0% 44.7%

British

Columbia

13.5% 28.5% 28.5% 45.2%

Manitoba 12.0% 30.0% 30.0% 46.7%

New

Brunswick

16.0% 30.0% 29.5% 46.7/45.7%

Newfoundland 15.0% 23.0% 32.0% 48.7%

Nova Scotia 16.0% 34.0% 34.0% 50.7%

Ontario 16.5% 28.0% 30.0% 48.7/46.7%

Prince Edward

Island

12.0% 34.0% 34.0% 50.7%

Quebec 19.0% 29.9% 29.9% 46.6%

Saskatchewan 15.5% 28.0% 30.0% 46.7%

1 If Investment income (other than dividends from taxable Canadian corporations) creates RDTOH, the tax rate rises

6.67 percentage points.

APPENDIX "C"

2010

CAPITAL TAX RATES

PROVINCE MAXIMUM RATE

Manitoba

(on taxable capital ≤ $10M)

(on taxable capital > $10M)

.1%

.3%

Québec .12%

Nova Scotia1

(on taxable capital < $10M)

(on taxable capital ≥ $10M)

.2%

.1%

All provinces have a capital tax for financial institutions.

1 Effective July 1, 2010.

APPENDIX “D”

COMPARISON OF 2010 TOP MARGINAL RATES FOR ELIGIBLE AND NON-

ELIGIBLE DIVIDENDS

PROVINCE

ELIGIBLE DIVIDEND NON-ELIGIBLE DIVIDEND

British Columbia

21.45% 33.71%

Alberta

15.88% 27.21%

Saskatchewan

21.64% 30.83%

Manitoba

25.09% 38.21%

Ontario

26.57% 32.57%

Québec

30.68% 36.35%

New Brunswick

19.46% 30.83%

Nova Scotia

29.79% 33.06%

Prince Edward Island

25.96% 39.66%

Newfoundland 24.37% 32.71%

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CHOICE OF BUSINESS VEHICLES · may prefer to conduct itself as a proprietorship to avoid these costs. (c) The business may incur losses at the outset which the individual may wish