In December 1992, the taxpayer and her son each rolled into a newly formed partnership a 50% undivided interest in certain real properties. As consideration, the partnership issued 1.252 million redeemable Class A partnership units to each of the taxpayer and her son, and assumed certain liabilities associated with the properties.
In January 1993, the partnership issued 100 Class C units to the son’s family trust for cash consideration of $100. The purpose of the structure was to effect an estate freeze under which future growth in the transferred properties would accrue to the trust beneficiaries.
The partnership had profits of approximately $342,000 in 1994; $108,000 was allocated to each of the taxpayer and her son on their Class A units and the remaining $126,000 was allocated to the son’s family trust on the Class C units.
The CRA reassessed to include 50% ($63,000) of the allocation to the son’s family trust in the taxpayer’s income in accordance with a specific provision in the Income Tax Act prohibiting the sharing of income in unreasonable proportions. The CRA’s view was that this treatment was appropriate because the taxpayer had invested 50% of the capital into the partnership and was responsible for 50% of the partnership’s conduct under the partnership agreement.
The taxpayer appealed to the TCC, arguing that, despite the nominal contributions of the holders of the Class C units, their income allocation was reasonable because it gave effect to the kind of corporate estate freeze that is generally considered acceptable income tax planning.
The Tax Court decision
The TCC Judge, Justice Cameron McArthur, stated that he began “from the premise that structured properly, a partnership can replace a typical estate freeze through a corporation.” However, he concluded that the terms of this partnership deviated substantially from a typical estate freeze, and therefore dismissed the appeal.
The main “deviation,” in the judge’s view, was that the value of the Class A units issued to the taxpayer was less than the value of the properties that had been transferred to the partnership in exchange for those units.
The judge considered the following main factors:
- The partnership agreement provided that all losses in respect of the properties were to be allocated to the Class A units held by the taxpayer.
- The Class A unitholders were required to fund cash requirements in relation to the ongoing operation of the properties.
- The taxpayer could not unilaterally have her Class A units redeemed.
The partnership agreement contained a price adjustment clause in respect of the redemption value of the Class A units issued for the properties in the event that the fair market value of the properties was redetermined by any tax authority. However, this did not assist the taxpayer, since it was not the value of the properties that was at issue, but the value of the units issued in exchange for the properties.
As a result, the TCC upheld the CRA’s reassessment, which included in the taxpayer’s income 50% of the 1994 partnership income that had been allocated to the family trust under the partnership agreement.
The Federal Court of Appeal decision
The taxpayer’s appeal to the FCA was dismissed on the basis that the TCC judge’s conclusion was reasonably open on the record before him. Unfortunately, the FCA did not express an opinion on the efficacy of partnership estate freezes:
“We note that Justice McArthur accepted the notion that it is possible to achieve an acceptable estate freeze through a partnership. We do not consider it necessary to express an opinion on that issue and we decline to do so.” (paragraph 7)
What the decision means
As a result of this decision, you should exercise caution before undertaking a partnership estate freeze. Be cognizant of a possible reallocation under the Income Tax Act’s unreasonable proportions provisions. And ensure that the relevant price-adjustment clause is drafted properly so it covers not only a redetermination of the value of the transferred properties, but also the value of the units issued in exchange for the properties.
When you can use a corporate freeze, it may be preferable to do so. Alternatively, if it is necessary to use a partnership freeze — for example, where the freeze property is land inventory or is otherwise not eligible for a corporate rollover — you should consider obtaining an advance ruling from the CRA.