UNREASONABLE INCOME ALLOCATIONS
In a June 12, 2019 Tax Court of Canada case (Aquilini et al. vs. H.M.Q., 2015-129(IT)G) at issue was whether income allocations among partners were reasonable.
The structure (simplified)
While many more entities and partnerships were involved in the transactions, we will only consider the key parties. A partnership (AIGLP) held, among other assets, a 50% interest in the Vancouver Canucks.
A complex income allocation formula between numerous related partners effectively provided that the first $1 million of net income would be allocated to various individual family members (the mother and her three sons) and partnerships controlled by the family. The remainder would be allocated to four family trusts, one for each individual. Further, losses could only be allocated to the sons. This provision was purportedly included to protect the mother’s capital.
The transaction (simplified)
In 2007, the family decided to purchase the remaining 50% interest in the Vancouver Canucks. In order to raise sufficient capital, some large assets were sold by the partnership. This resulted in taxable capital gains of approximately $47 million.
The general partner (638Co) acquired a 19.5% interest in an insolvent corporation (JPY) having capital losses of $121.2 million carried over from prior years. Employees of the AIGLP group were appointed to 2 of the 3 director roles, and the family admitted that they controlled JPY. The four family trusts then added JPY as a beneficiary.
Since the family trusts were entitled to any earnings in excess of the first $1 million, most of the $47 million taxable capital gains, plus another $600,000 in income, was allocated to them. Each family trust then made their gains payable to the newly introduced corporate beneficiary, JPY. JPY then applied its capital losses to offset the gains. No income was distributed to the trust beneficiaries. The balances payable were documented with promissory notes.
Taxpayers lose – income allocation
There are two deeming provisions which permit CRA to reallocate the partnership income for tax purposes, which the Court examined.
The first provision (Subsection 103(1.1)) allows CRA to deem income in the partners’ hands in amounts which are reasonable under the circumstances. This provision applies where two or more non-arm’s length partners agree to share income or loss in a way that is not reasonable having regard to capital invested and work performed for the partnership, or other factors as may be relevant. The Court stated that this provision does not require a purpose of reducing or deferring taxes and is intended to prevent income splitting between related parties.
The Court determined that arm’s length parties would not have accepted such levels and types of remuneration when considering the capital and work contributions. From a capital investment perspective, the mother would receive 35% of the first $1 million with only an 8.8% contribution. The sons would each receive 17.3% despite a 23.7% contribution. All income over $1 million (approximately $48 million in 2017) would be allocated to the trusts despite a capital contribution of less than 0.001%. This imbalance was increased by the fact that, despite receiving less from a capital contribution perspective, the sons also contributed significantly more work than their mother. In addition, they also shouldered the risk of loss. The Court also concluded that only factors pertaining to business considerations were relevant.
Given the large discrepancy between income allocation and inputs, the Court determined that the distributions were unreasonable. Further, it opined that CRA’s method for determining income allocations was reasonable in light of the absence of any alternatives put forward by the taxpayers. CRA had used each partner’s proportional share of capital contributed prior to income allocations.
Although the taxpayers’ appeals were disallowed on this basis, the Court also considered whether a deemed allocation under the other provision (Subsection 103(1)) would apply. This provision applies regardless of whether the partners act at arm’s length. It requires only that the principal reason for the agreement is reasonably considered to be the reduction or postponement of tax.
The Court determined that tax was the primary motivating factor since it was demonstrated that the family went back to their advisors to seek a method to reduce taxes at the trust level as soon as the need arose. This was complemented by the fact that the trust agreements allowed for a third party to be appointed beneficiary which appeared to contradict the stated intent of passing the growth to lineal descendants. The Court determined that the conditions of this provision were satisfied such that CRA could deem a reasonable allocation of income to the partners under this provision as well.
For further information see Video Tax News Monthly Tax Update Newsletter, Issue No. 456.