1.1Recommended Exercises and Self-Study Problems

3520-10: Last updated on November 3, 2013 1-7

1Lecture 10: Basic rules for Partners and Partnerships, Part IV Tax and Personal Services Businesses

1.1Recommended Exercises and Self-study Problems

Refundable Part I and Part IV Tax
Exercises 13-3 to 13-5
Self-study Problem 13-3
Note: for purposes of this course, you are not responsible for material relating to foreign taxes as it pertains to refundable taxes.
Personal Services Businesses
Partnerships
Exercises 18-1 to 18-6
Self-study Problems 18-3 and 18-4

2Refundable Part I Tax on Investment Income [13-25 to 13-42] and [13-48 to 13-68]

Additional Refundable Tax (ART) is a refundable tax on the investment income of a CCPC.
It is equal to 6-2/3 percent of the lesser of:
The corporation’s “aggregate investment income” for the year; and
The amount, if any, by which the corporation’s taxable income exceeds the amount eligible for the small business deduction.
Aggregate investment income – see definition in CTP 13-25 to 13-27
Makes it less attractive to keep investment income within the corporate structure in order to defer taxes (due to lower corporate tax rate).
Integration and ART:
With the addition of the ART on the investment income of a CCPC, the investment income ends up being taxed at combined federal/provincial rates ranging from 44-2/3 percent to 50-2/3 percent
This is more than 2x the 20% rate required for perfect integration.
See example at 13-50 to 13-54
Solution: when the corporation distributes a dividend, a part of this tax is refunded
The refund is $1 for every $3 of dividends paid.
See example at 13-62 to 13-64

3Refundable Part IV Tax [13-69 to 13-76] and [13-97 to 13-98]

Part IV tax is assessed on dividends received by a private corporation (regardless of whether Canadian controlled or not) from certain other corporations.
“Subject Corporations” are treated as private corporations
See definition of “Subject Corporation” in CTP 13-72.
Tax is assessed at a rate of 33-1/3 percent.
Refunds of Part IV tax are equal to $1 for each $3 of dividends paid.
Applies to portfolio dividends and some dividends from connected corporations

3.1Portfolio Dividends [13-77 to 13-84]

Under general rules for inter-corporate dividends, the dividend would be deductible in the calculation of the corporation’s taxable income
Potential for significant deferral of taxes until the corporation pays out dividends to individual shareholders.
Part IV Tax – When a private corporation receives a dividend on shares that are being held as a portfolio investment, the corporation pays Part IV tax of 33-1/3% of the dividend received. This tax is refunded $1 for each $3 of dividends subsequently paid out by the corporation.
33-1/3% tax rate chosen to make it unattractive to use the corporation to defer taxes

3.2Dividends from Connected Corporations [13-85 to 13-96]

Connected corporation (See CTP 13-77):
A controlled corporation, or
A corporation in which more than 10% of voting shares AND more than 10% of the FMV of all the issued shares are owned.
When a private corporation receives a dividend from a connected private corporation that has received a dividend refund as a result of paying the dividend, the recipient corporation pays Part IV tax equal to its share of the refund received by the paying corporation.
Read CTP 13-90 to see how this Part IV tax maintains integration when dealing with connected corporations.

4Refundable Dividend Tax on Hand (RDTOH) [13-99 to 13-103]

Tracking mechanism to keep track of amounts of taxes that have been paid that are eligible for a refund.
Keeps track of the various types of refundable taxes:
Refundable portion of Part I tax paid; least of:
26-2/3 percent of aggregate investment income
26-2/3 percent of the amount, if any, by which taxable income exceeds the amount eligible for the small business deduction
Part I tax payable
Part IV tax on dividends received (portfolio dividends and connected corporations)
Calculated as follows:
Opening RDTOH balance (closing prior year balance)
- dividend refund from preceding year
+ refundable portion of Part I tax paid
+ part IV tax on dividends received
Dividend refund is available on any taxable dividend that is paid by the corporation
The dividend refund in a given year is limited to the balance in the RDTOH account.
The dividend refund for the year will be equal to the lesser of the balance in the RDTOH account at the end of the year, and one-third of the dividends paid for the year.
Refer to CTP 13-120 and 13-121 for a sample calculation of the RDTOH balance (disregard the foreign tax credits).

5Personal Services Business (PSB) [12-112 to 12-118]

There is a strong incentive (lower tax rate, hence tax deferral) to have income directed into a corporation that qualifies for the small business deduction.
See CTP 12-114 for definition of “personal services business”:
An incorporated employee or any person related to the incorporated employee is a specified shareholder (owns at least 10% interest in the company) of the corporation and would be regarded as an officer/employee of the entity for which the services are performed.
2 exceptions:
Corporation employs more than 5 full time employees throughout year
The amount paid/payable to the corporation in the year for the services is received/receivable by it from a corporation with which it was associated in the year.
PSBs are not eligible for the small business deduction.
Also not eligible for the general rate reduction.
The only deductions permitted by the corporation are:
Salaries, wages, benefits, other remuneration paid in the year to the individual performing the services
Other expenses that would normally be deductible against employment income
Therefore it is not beneficial from a tax perspective to be classified as a PSB.

6Partnerships: Flow-through Entities

Partnerships are often referred to as flow through entities because the income earned by the partnership can be flowed through to investors who have an interest in the partnership
See 18-4

7Partners and Partnerships

A partnership is an automatic flow through
For example, if a partnership earns $100,000 and there are 10 partners (10% each), each partner earns and must pay tax on $10,000. Note: partners can decide to share income/losses in any manner that they wish (i.e., they do not have to equally share in the income/losses of the partnership)
Further, each type of income flowed through maintains its character (e.g., business income, interest income, etc.)
See CTP 18-1 to 18-5
There are basically three types of partnerships:
general partnerships (which have no limited liability protection)
limited partnerships (used for investments in tax shelters, oil & gas and real estate) and
limited liability partnerships (referred to as LLPs and used by accounting and law firms)
The last two types of partnerships are formed under provincial legislation and provide some limited liability protection for partners
The limited liability protection is different in each case and has tax consequences
See CTP 18-16 to 18-23

7.1Allocations to Partners and Partner Expenses [ITA 96] [18-37 to 18-59]

The partnership computes its Division B net income as if it were a taxpayer (even though it is not a taxpayer)
Each partner is allocated a % of this Division B net income of the partnership and must pay tax on this income (whether or not they receive it)
The income is added to the ACB of the partner’s “partnership interest”. The partnership interest is a capital property and it represents the partner’s ownership interest in the partnership
When partners actually take money out of the partnership it is called a “draw” or “drawing” (because it is generally a withdrawal of cash)
Draws are not taxed because the income is taxed as it is earned
Instead, the draw reduces the ACB of the partner’s partnership interest

Most deductions are claimed at the partnership level
This includes discretionary deductions (such as CCA and reserves)
The partnership must decide on the amount and will usually claim the maximum amount of CCA
There are a few items computed at the “partner” level rather than by the entire “partnership” Here is a list of the five most common items:
Dividends from taxable Canadian corporations earned in the partnership are allocated (and it keeps its form) to the partners
theyare grossed up and have dividend tax credits in the hands of individual partners or
are eligible for ITA 112 deduction in the hands of a corporate partner
Business-related expenses which are paid by the partner rather than the partnership can be deducted as a business expense (and are eligible for a GST/HST rebate)
Common examples are auto expenses, promotion, meals & entertainment, etc.
Losses (non capital losses, net capital losses, etc.) incurred in the partnership are allocated (and keep their form) to the partners
Charitable donations made by the partnership (e.g. if the XYZ partnership contributes to the United Way). A 10% partner would be able to claim a donation = 10% of the amount donated
an individual partner would get a credit under ITA 118.1 for his/her 10% share of the donation
a corporate partner would gets a deduction under ITA 110.1(1)(a) for its 10% share of the donation
Federal political contributions made by the partnership. The partners would be able to claim a political tax credit under ITA 127(3) for their % share of the political contribution. Note: corporations and unions are no longer allowed to make federal political contributions
Note: for charitable donations and federal political contributions
the ACB of a partner’s partnership interest is reduced by the partner’s % share of any charitable donation or political donation made by the partnership
It is useful to think of this as a “non-cash” draw
Instead of cash, the partner gets a donation to claim on the partner’s tax return

7.2Partnership Interest

ACB of partnership interest (= partner's equity in a partnership for tax purposes)
In an uncomplicated situation, the ACB of a partnership interest is
partner’s initial cost + partner’s share of income of the partnership - partner’s share of losses of the partnership - drawings by the partner
But there are complications requiring extra adjustments for certain tax-free amounts to maintain integration (so that income earned tax-free to the partnership can be received tax-free by the partner). That is, the ACB is increased
for the full amount of a capital gain (CG) and profit on the sale of eligible capital property (ECP) (and similarly decreased for the full amount of a capital loss, CL)
for tax free capital dividends and the tax-free profit when life insurance proceeds are received (life insurance proceeds minus the ACB of the policy; note: the ACB is zero for simple life insurance, hence life insurance proceeds are typically received tax free)
See 18-60 to 18-64 and18-72 to 18-80

7.2.1ITA 53 Rules (ACB of partnership interest)

When these complications are added, we get the technical ITA 53 rules for calculating the ACB of partnership interest
= Original cost of the partnership interest
plus ITA 53(1)(e) adjustments:
Income computed on the basis that:
CG and CL and gains on eligible capital property (ECP) are computed on a 100% basis
non-taxable capital dividends and life insurance proceeds are included
Capital contributions
Other (not covered in this course)
minus ITA 53(2)(c) and (o) adjustments:
Losses computed on the same basis as above
Drawings (including partner salaries)
Other (investment tax credits, foreign tax credits, charitable and political donations allocated)

7.2.2If the ACB of a partnership interest is negative at any point/ Interest Expense

there is no immediate CG (ITA 40(3)(a)) unless
the interest has been disposed of
it is a residual interest in a partnership (e.g. the interest of a retired partner) or
the partner is a limited partner of a limited partnership (not an LLP)
How could the ACB of a partnership interest be negative?
Answer
If the partner’s share of losses and/or draws exceeds contributions and/or income
Is Interest expense incurred to purchase a partnership interest is deductible?
Answer
Yes, as long as the partnership is earning income from business or property, all other conditions in ITA 20(1)(c) are met and no other provision of the Act applies to stop the deduction

7.2.3Admission of new partner and withdrawal of a partner [18-65 to 18-71]

see example in CTP 18-67 to 18-71
If a new partner is admitted to the partnership the price paid by the new partner to acquire his/her partnership interest is the initial adjusted cost base (ACB) of his/her partnership interest. The new partner may buy out an existing partner’s partnership interest or he/she may contribute assets to the partnership
If a partner leaves the partnership, the partner typically will sell his/her partnership interest (to a new partner or to the partnership) in return for proceeds of disposition (P of D). If the P of D exceeds the (former) partner’s ACB of his/her partnership interest the (former) partner will have a capital gain. If the P of D is less than the (former) partner’s ACB of his/her partnership interest the (former) partner will have a capital loss

7.3Partnerships and Tax Planning

There are complications to using partnerships for tax planning. Here are some reasons:
Partnerships with an individual as a partner must have a December 31 year-end
The 2011 Budget has made changes that affect corporations who are members of a partnership
Certain corporate partners will no longer be able to defer income earned through a partnership. These changes are discussed in ADMS 4562

The CRA has the power to reallocate partnership income
if the allocation was made to defer or reduce income tax payable [ITA 103(1)] or
if it is to make an allocation between non-arm’s length partners (e.g. spouses or siblings) more reasonable [ITA 103(1.1)]
Attribution rules
The attribution rules obviously apply to property income (e.g., interest, dividend, rental income) and capital gains (in the case of spouses) earned through a partnership
But business income earned through a partnership is deemed to be property income for the purposes of the attribution rules if the partner is a limited partner or not actively engaged in the business [ITA 96(1.8)]
This deeming rule was introduced when it became popular to loan spouses and minors money to invest in partnerships that owned nursing homes and hotels

This edition of the notes was updated by Priya Shah [.