Case Commentary – Canada v Green, 2017 FCA 107

In Canada v Green,[1] the Federal Court of Appeal affirmed the Tax Court of Canada's decision[2] and rejected the long-standing position of the Canada Revenue Agency (the "CRA") in the context of limited partnerships that, in tiered structures, losses from business or property of the lower-tier partnership allocated to its member partnership, in excess of the upper-tier partnership's at-risk amount, cannot be used by either the upper-tier partnership or its partners.[3]

The decision in Green marks the adoption of a purposive approach to the interpretation of deeming rules, improves planning opportunities, and introduces certain compliance challenges in keeping track of partnership income and losses in tiered structures.

Statutory Framework

The at-risk rules are an exception to the flow-through of losses from partnerships to their members, under paragraph 96(1)(g) of the Income Tax Act (Canada) (the "Act").[4]  Pursuant to subsection 96(2.1), a taxpayer that is a limited partner[5] of a limited partnership cannot deduct from its income for the year its share of the partnership’s losses in excess of its at-risk amount in respect of the partnership interest, as reflected at the end of the partnership’s fiscal period.  Paragraph 96(2.1)(d) provides that the amount by which the taxpayer's share of the losses of a limited partnership exceeds that partner's at-risk amount in that limited partnership shall not be included in computing the taxpayer's non-capital loss for the year.  Instead, the excess losses are deemed to be limited partnership losses in respect of the partnership interest, and such losses can be carried forward indefinitely.  A taxpayer is entitled to deduct limited partnership losses in future taxation years, under paragraph 111(1)(e), to the extent of its at-risk amount in respect of the partnership at the end of the last fiscal year of the partnership.

A taxpayer's at-risk amount in respect of a partnership is defined in subsection 96(2.2). It is comprised of the taxpayer's adjusted cost base of its interest in the partnership, plus its share of the income from any source for the fiscal period of the partnership, minus amounts that are considered to reduce the partner’s economic investment in the partnership, such as certain non-arm's length debts[6] and amounts or benefits that reduce the limited partner’s exposure to losses that it may sustain as a member of the partnership.[7]  By consequence, subsection 96(2.1) and paragraph 111(1)(e) generally restrict a limited partner's ability to deduct losses of a partnership to the extent the losses exceed its investment in and income from the partnership. 

Additionally, under subsection 102(2), for the purposes of subdivision j, reference to a taxpayer who is a member of a particular partnership includes reference to another partnership that is a member of such a lower-tier partnership.  As such, it could be interpreted that limited partners that are partnerships are taxpayers for the purposes of sections 96 through 103 of the Act. [8] 

CRA Published Policy Prior to Green

CRA's historical position was that, as a result of subsection 102(2), the losses allocated by a limited partnership to each of its members, including another partnership, will be deductible by each member only to a maximum of each member's at-risk amount, defined in subsection 96(2.2).[9]  As the loss in excess of the member's at-risk amount is deemed to be a limited partnership loss by paragraph 96(2.1)(e), partnerships members of a lower-tier partnership could have limited partnership losses.  However, partnerships are not taxpayers for the purposes of section 111.  By consequence, regardless of an increase in their at-risk amount, partnership members of a lower-tier partnership could not deduct their limited partnership losses, pursuant to paragraph 111(1)(e).

Additionally, CRA considered that subsection 96(1) does not allow the transfer of limited partnership losses to an upper-tier partnership's members.  Therefore, limited partnership losses were effectively lost in the case of multi-tier limited partnerships.[10]  The Crown adopted CRA's administrative position in the Green appeal.

Following the same strict interpretation of subsection 102(2), the CRA stated that the retiring partner provisions in subsection 96(1.1) would equally apply in the context of tiered partnerships.[11]  Additionally, the CRA stated that the rules applicable when a partnership ceases to exist under subsection 98(3), may be used when one of the partners is itself a partnership or even if all the partners are partnerships.[12]

Facts

The taxpayers in Green were limited partners of Monarch Entertainment 1994 Master Limited Partnership ("MLP") throughout the years 1996 to 2009.  In turn, MLP was a limited partner in 31 production services limited partnerships (the "PSLPs").  Each PSLP incurred business losses for its 1996 through 2009 fiscal years, most of which were allocated to MLP.  MLP allocated the business losses from the PSLPs to its partners, including the taxpayers.  The at-risk amount for 1996 to 2008, of each taxpayer in MLP was nil and of MLP in each of the PSLPs was also nil.  The taxpayers added the losses allocated to them by MLP over the years to their limited partnership losses.

In 2009, as a result of a capital gain that was allocated by MLP to its limited partners, the at-risk amount of the taxpayers in MLP increased.  Each taxpayer then claimed a portion of the accumulated limited partnership losses in respect of MLP to offset the allocated income.

Court Hearing

Green was heard as application for a determination of two questions of law under Rule 58(1)(a) of the Tax Court of Canada Rules (General Procedure).  The questions of law considered were:

1. Whether, in a two-tiered partnership structure, where the upper-tier partnership has no at-risk amount in respect of the lower-tier partnership at the end of the particular fiscal period, business losses incurred by the lower-tier partnership in the particular fiscal period retain their character as business losses of the upper-tier partnership and are thus available to be allocated to the partners of the upper-tier partnership as business losses, which would then be subject to the at-risk rules?

2. If the answer to the first question was negative, whether a limited partnership loss of the upper-tier partnership in the lower-tier partnership flows through to the partners of the upper-tier partnership such that they have a limited partnership loss?

The Tax Court judge answered the first question in the affirmative, meaning that business losses incurred in the PSLPs were available to be allocated to the partners of MLP as business losses, and subject to the at-risk rules in the taxpayer’s hands.  By consequence, the Tax Court judge did not proceed to the second question.  The Crown appealed from that decision.

The Federal Court of Appeal dismissed the appeal.  The Court held that the standard of review was correctness, as the only issue in the appeal raised a question of law.[13]  In the Court's view, the applicable statutory provisions should not be read in isolation, "[r]ather the context and purpose are important in interpreting the words that are used."[14]

Tax Court of Canada Decision

The Tax Court held that, having regard to the text, context, and purpose of subsection 96(2.1), the business losses of the lower-tier partnership flow out to the partners of the upper-tier partnership and retain their character as business losses at each level (subject to the application of subsection 96(2.1) to those ultimate partners), and are not treated as limited partnership losses of the upper-tier partnership.[15] 

The Court held that subsection 96(2.1) applies for purposes of determining a taxpayer's income under section 3 of the Act and taxable income under section 111, and that the purpose of the at-risk rules "is not to deny absolutely the losses in excess of a limited partner's at-risk amount but, rather, to defer deduction of the excess until a time when the partnership has generated income or the partner's at-risk amount has increased for some other reason".[16]  Thus, although a partnership member of a partnership may be treated as a taxpayer for purposes of sections 96 to 103, subsection 96(2.1) does not apply to a partnership because it does not compute income under section 3 or taxable income under section 111.[17]

Federal Court of Appeal Decision

The Federal Court of Appeal agreed with the textual, contextual and purposive approach of the Tax Court.  The Court of Appeal started its analysis by noting that the purpose of subsection 96(1) is not to determine the income of a partnership for purposes of determining the amount of tax payable by that partnership, but rather, "to ensure that any income or loss realized by the partnership is allocated to its partners and that the source of that income or loss is maintained to allow the members of that partnership to identify the source of income or loss for the purposes of section 3 of the ITA."[18]

The purpose of allocating partnership income or loss to partners, while maintaining their sources, drove the Court's analysis of the relevant provisions.  The Court read paragraph 96(2.1)(c), under which a taxpayer is not allowed to deduct losses in excess to its at-risk amount from income by reference to the income computation, in section 3.  Symmetrically, the Court interpreted paragraph 96(2.1)(d), under which a taxpayer is not allowed to add such losses to its non-capital losses, by reference to the deductible loss computation, in section 111.  As both sections 3 and 111 only apply to taxpayers, and partnerships are not considered taxpayers for purposes of these sections, the Court concluded that paragraphs 96(2.1)(c) and (d) also do not apply to partnerships.[19]  The Court used this conclusion as a stepping-stone for interpreting paragraph 96(2.1)(e).

The tension between the Crown's position and the taxpayers' position resulted from the fact that paragraph 111(1)(e), allowing for deduction of limited partnership losses, is outside subdivision j, whereas subsection 96(2.1), that creates limited partnership losses, is inside of subdivision j. By virtue of subsection 102(2), a partnership is a taxpayer only for the purposes of subdivision j. In the Crown’s view, unlike paragraphs 96(2.1)(d) and (e), paragraph 96(2.1)(c) makes reference to a concept within the scope of subdivision j, i.e. the concept of computing income of a member of a partnership in subsection 96(1), and therefore paragraph 96(2.1)(e) clearly applied to an upper-tier partnership. However, the deduction for limited partnership losses in a future year in paragraph 111(1)(e) is only available for purposes of computing taxable income of a taxpayer, which is inapplicable to partnerships.

The Court considered that paragraphs 96(2.1)(e) and 111(1)(e) fulfil the same legislative intent; to defer a member’s limited partnership losses until the member has the necessary at-risk amount to utilize them.  The Court stated that Parliament would not have intended to apply the restriction on limited partnership losses to upper-tier partnerships but deny such partnerships the benefit of future deductions, and therefore concluded that paragraph 96(2.1)(e) does not apply to a partnership that is a member of a limited partnership.[20]

The Court also based its decision on the Supreme Court of Canada's dictum in Stewart v R,[21] that "[i]t is undisputed that the concept of a 'source of income' is fundamental to the Canadian tax system."  The Crown's approach resulted in combining all income and losses of the lower-tier partnership into a single amount.  By contrast, under paragraphs 96(1)(f) and (g), a taxpayer that is a member of a partnership must compute its income and losses, in general terms, as if the amount of the income or loss of the partnership from any source was the income or loss of the taxpayer from such source.  Thus, the Court found that:

Parliament did not intend for a partnership that is a member of another partnership to compute income.  Rather, Parliament intended for the sources of income (or loss) to be kept separate and retain their identity as income (or loss) from a particular source as they are allocated from one partnership to another partnership and then to the partners of that second partnership (and so on as the case may be).[22]

The Court decided that by not applying paragraph 96(2.1)(e) to tiered partnerships, the lower-tier partnership would allocate its income (or loss) on a source-by-source basis, and, in turn, the upper-tier partnership would do likewise.  Thus, the scheme of the Act is respected and taxpayers who are liable to pay tax are able to compute their income as provided in section 3, aggregating income from each source under paragraph 3(a) and paragraph 3(b) and deducting from income the loss from each source under paragraph 3(d).

Commentary

The Green decision overruled a narrow administrative position of the CRA and applied a purposive interpretation of the Act.  Additionally, the decision opens up planning opportunities.  Nevertheless, the judgement also introduces a level of uncertainty concerning tracking income and losses in tiered partnerships and the requirement to calculate income under certain provisions of the Act.[23]

Purposive Interpretation of Deeming Rules

Although the Federal Court of Appeal's decision centered around the interpretation of paragraph 96(2.1)(e), the underlying question was whether the provision in subsection 102(2) should apply for the purposes of subsection 96(2.1).  For the purposes of subdivision j, subsection 102(2) could be considered a deeming rule for members of partnerships.  Both the Tax Court and the Federal Court of Appeal decided to interpret this deeming provision restrictively, as dictated by the context and purpose of the relevant sections.

The purposive approach to the construction of a deeming rule entails that whether a deeming provision should be given a strict or expansive interpretation depends on the relationship between the object and purpose of the deeming provision and those of the provisions to which it is sought to be applied.[24]  For example, in Gaston Cellard Inc c R,[25] the Tax Court considered the purpose of the investment tax credit rules in order to decide whether the deemed cost provision in paragraph 44(1)(f) extended to those rules.[26]

Deeming provisions should be interpreted to avoid absurd results.  This approach to the interpretation of deeming rules is also favoured in the United Kingdom, most notably in IRC v Metrolands Ltd,[27] a case that dealt with the effects of a deeming rule on a taxpayer's liability to pay a development tax assessment, in which the Chancery Division of the UK High Court of Justice stated:

When considering the extent to which a deeming provision should be applied, the court is entitled and bound to ascertain for what purposes and between what persons the statutory fiction is to be resorted to. It will not always be clear what those purposes are. If the application of the provision would lead to an unjust, anomalous or absurd result then, unless its application would clearly be within the purposes of the fiction, it should not be applied. If on the other hand, its application would not lead to any such result then, unless that would clearly be outside the purposes of the fiction, it should be applied.[28]

In Green, the Courts found it unjustified that investors in single-tiered partnerships would benefit from limited partnership losses, while investors in tiered partnerships would be denied that benefit.[29]  Therefore, they effectively refused to apply the fiction, under subsection 102(2), that a partnership would be a taxpayer for the purposes of paragraphs 96(2.1)(c), (d), and (e).

After the Green decision, the CRA may need to reconsider its administrative policy[30] concerning tiered partnerships in the context of subdivision j.  The Court has clarified that a textual interpretation of the deeming rule in subsection 102(2) is no longer sufficient to reflect the legislative intent of such rule.

Attractive Alternative to Stacked Corporations

A significant benefit of tiered partnerships is that they allow for the mixing of income and losses of various lower tier partnerships, whereas, with corporate subsidiaries, losses of one subsidiary are trapped inside that subsidiary, unless planning transactions are undertaken to unlock them.

Now that the Federal Court of Appeal has confirmed that business losses in a lower-tier partnership allocated to an upper-tier partnership in excess of its at-risk amount continue to be treated as business losses in the hands of the upper-tier limited partnership, such losses can be in turn allocated to the limited partners of the upper-tier partnership and deducted by those partners subject to their at-risk amount in the upper-tier partnership.  This outcome could favour the use of tiered partnerships because it allows for the consolidation of income and losses in tiered partnership structures without undergoing additional structuring, as in the case of stacked corporations.[31]

The Federal Court of Appeal acknowledged that its decision could allow losses of one lower-tier partnership to be claimed against the income of another lower-tier partnership at the ultimate partner level and that the at-risk rules could be avoided entirely by using a general partnership as an upper-tier partnership.  However, the Court stated that such concerns did not outweigh the negative implications associated with the Crown's interpretation of the at-risk rules. In any event, the planning opportunities opened by Green could be addressed by legislative amendment or by the application of the general anti-avoidance rule, in appropriate factual circumstances.[32]

Partnership Income Calculation

The Federal Court's statement that "Parliament did not intend for a partnership that is a member of another partnership to compute income" appears to be at odds with several provisions of the Act that infer that a partnership computes income.  For example, under subparagraph 53(1)(e)(i), members of a partnership get a step-up in the adjusted cost base of their interests in the partnership in respect of their share of the income of the partnership allocated to the partners.  Additionally, under subsection 91(4.6), differences between the foreign law and the Act in the manner of computing income of the partnership are not taken into account for the purposes of the foreign accrual tax denial rules in subsection 91(4.1).

However, the Court's statement is consistent with the aforementioned provisions, and should not be interpreted as to deny a step-up in basis under subparagraph 53(1)(e)(i).  Income from a lower-tier partnership is not income from a source that is a limited partnership interest.  Rather, income is only computed at the lower-tier partnership level and, then, the income so determined flows through the upper-tier partnership to its members who are taxpayers and not partnerships.  By consequence, the upper-tier partnership does not compute the income flowed through it because that has already been done at the lower-partnership level. Instead, the lower-tier partnership income is the income of the upper-tier partnership, resulting in a step-up in adjusted cost base of the members of the upper-partnership in the upper-tier partnership interest when allocated to the members of the lower-tier partnership.[33]

Finally, in terms of losses, as a result of Green, tiered partnerships will no longer have to track and allocate its limited partnership losses from the lower tier-partnership.  Instead they will track and allocate business and property losses incurred in the lower tier-partnership, all the way up to the taxpayer-members of upper-tier partnerships.