Partnership Freeze Revisited

Spring 2011

The Federal Court of Appeal recently ruled on a partnership freeze
structure, unanimously dismissing the taxpayer’s appeal in Krauss (2010 FCA 284). Krauss
is the first reported case dealing with a partnership freeze.

The taxpayer and her adult son (who was described as an able tax lawyer,
real property manager, and developer) co-owned certain real properties on Yonge
Street in Toronto. They developed a plan to effect an estate freeze by
transferring the properties to a partnership in order to accrue future growth
in their value to the benefit of a family trust.

On December 31, 1992, the taxpayer and her son rolled their 50 percent
undivided interests in the properties into a partnership — established earlier
that day — in exchange for class A preferred partnership units, redeemable at
the properties’ fair market value less the liabilities assumed by the partnership. Their
capital accounts were credited with the same amount.  The son and the
taxpayer’s company also contributed other real property to the partnership for
class B units similar to the class A units. On January 2, 1993, the partnership
issued class C units (the growth units) to a family trust for the benefit of
the son’s wife and children in exchange for a $100 cash contribution. The class
A and class B units’ redemption prices were subject to price adjustment
clauses.

In 1994, the Yonge Street properties generated a partnership profit of
$343,431, of which $216,710 was allocated equally between the taxpayer’s and
her son’s class A preferred units, and the $126,721 balance was allocated to
the trust’s class C growth units.

The CRA has consistently refused to rule on partnership freezes, dangling
the threat of reassessments that reallocate the partners’ income (or loss) from
the partnership under subsection 103(1) or (1.1) of the Income Tax Act.
Subsection 103(1) may apply if the principal reason for the allocation can
reasonably be considered to be the reduction or postponement of tax. 
Subsection 103(1.1) requires that the allocation between non-arm’s-length
partners be reasonable, having regard to their capital contributions and other
contributions to the partnership.

The Minister of Finance reassessed the taxpayer, adding 50 percent of the
trust’s allocation to the taxpayer’s income. The Minister said that subsections
103(1) and 103(1.1) of the Income Tax Act prevented partnership estate
freezes and entitled the Minister to reallocate income between the partners on
the basis of what was reasonable: the taxpayer had directly or indirectly
invested 50 percent of the capital and was 50 percent responsible for the
ongoing conduct of the partnership, and thus should be allocated 50 percent of
the income. The Minister also said that subsection 74.1(2) attributed to the
taxpayer the trust’s partnership income because she had indirectly transferred
property, namely, rights to income from the Yonge Street properties, to or for
the benefit of her grandchildren. (The Minister could not plead subsection
74.1(1) to attribute the income of the son’s wife to the taxpayer.)

At trial, the Tax Court (2009 TCC 597) concluded that subsection 103(1.1)
applied because the $126,721 income allocation to the family trust was
unreasonable; inter alia, the trust contributed only $100 of capital and
provided no services to the partnership. “Quite simply, an investment in real
estate with no risk of loss that yields a 126,721% return is beyond
unreasonable. It is delusive to the point of absurdity, and betrays something
more than aggressive . . . tax planning.”

Advisors’ attention was captured by obiter in the TCC’s decision to
the effect that nothing in the Act prevented an estate freeze through a
partnership if it was structured properly to replicate the economics of a
corporate estate freeze. But the Tax Court stated that the Krauss partnership
structure deviated from a typical estate freeze: (1) the taxpayer could not
unilaterally require a redemption of her preferred units; (2) losses from the
partnership’s properties were allocated entirely to the preferred units, and
the growth units had complete downside protection; and (3) any cash required
for partnership operations was to be funded by the taxpayer and her son as the
preferred unitholders.

The TCC also said that the attribution rule in subsection 74.1(2) applied
for the same reasons as in Romkey (2000 DTC 6047 (FCA)), in which the
taxpayers’ divestiture of rights to increased future dividends was an indirect
transfer of property to their children and gave rise to attribution. In Krauss,
the divestiture in favour of the trust by the taxpayer and her son of rights to
receive future rental and other income from the Yonge Street properties (above
the class A units’ return) was an indirect transfer of property to the son’s
children and gave rise to attribution.

The Federal Court of Appeal unanimously dismissed the taxpayer’s appeal. The
taxpayer argued that the trust’s income allocation was reasonable despite its
nominal partnership contribution, because the partnership freeze was
functionally analogous to a corporate freeze. The FCA said that the TCC was not
wrong in law to reject that argument because the partnership structure deviated
substantially from a typical estate freeze, and insofar as it was a factual
determination it was reasonably open to the TCC on the record. Even though the
TCC did not fully appreciate that the taxpayer and her son were entitled to
additional partnership units if they were required to meet cash calls, the FCA
said that that was not a material error and thus was no basis for it to
intervene.

Unfortunately, the FCA’s decision provides no guidance on when a partnership
freeze is considered acceptable income tax planning; the Court found that it
was not necessary to express any opinion on the issue and declined to do so.
The FCA’s support of the Minister’s subsection 103(1.1) challenge in Krauss means
that taxpayers cannot expect any softening of the CRA’s position on partnership
freeze transactions. A taxpayer bold enough to undertake a partnership freeze
after Krauss may be well advised to ensure that income and loss
allocations reasonably reflect the partners’ capital and other contributions.
Otherwise, he or she risks attack by the Minister under one or more of
subsections 103(1) and 103(1.1) and sections 74.1 and 74.2 of the Act.

*A version
of this article was originally published in Canadian
Tax Highlights,
Volume 18, Number 12, December 2010

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