“The CRA can reallocate partnership income allocations when they consider the allocations tax motivated.”
In the recent case of XCO Investments Limited (2007 FCA 53), the Federal Court of Appeal was asked to examine whether the Tax Court (Chief Justice Bowman) had properly applied the provisions of subsection 103(1) of the Income Tax Act. Subsection 103(1) allows the CRA to reallocate partnership income when the principal reason for the income allocation may reasonably be considered to be the reduction or postponement of tax. In other words, the CRA can reallocate partnership income allocations when they claim that the allocationsare tax motivated.
In this case, Woodwards Store Limited (“Woodwards”) became an 80% partner in a real estate rental partnership to use its non-capital losses against its taxable income. The actual investment was not equal to 80% of the value of the of the assets.Based on the terms of the partnership agreement, it was clear that Woodwards had no economic risk by becoming a partner. Woodwards became a partner in the same year that the underlying real estate of the partnership was disposed of. The proceeds of disposition were at all times held in escrow by the lawyers, so that funds would be secure.
The Federal Court of Appeal found no reason to overrule the Tax Court decision that Woodwards was not entitled to a significant amount of the partnership income and consequently the income allocated to Woodwards was to be reallocated to one of the other partners.
The CRA also raised the issue of GAAR. However, there was no need for the Court to deal with this. The provisions of subsection 103(1) were adequate to determine that the income had been inappropriately allocated.
Subsection 103(1) is a dangerous section that could be applied unexpectedly.Many tax practitioners allocate the income or loss of their partnership clients on a different basis each year. If the CRA feels that the income or loss allocation is only for tax purposes, the CRA has the ability to reallocate the partnership income or loss.
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