Tax Angles: The `At-Risk’ rules (Part 2)

Recent court decisions foiled Revenue Canada’s general attempt to limit a limited partners’ allocation of deductions to the amount of his liability for economic loss or “at-risk” amount. The moratorium on advance rulings for limited partnerships imposed since Oct 25, 1984, provided the Department of Finance with time to consider which allocations or deductions should be restricted and how the law should be changed to accomplish this restriction.

Resourceful investors should be aware that the federal budget of Feb 26 introduced new rules (the budget proposals) that will impose significant limitations on the ability of a limited partner to deduct losses and investment tax credits flowing out from a partnership that are in excess of his at risk amount. Further details of the budget proposals are included in a comprehensive Notice of Ways and Means and Motion tabled on July 11.

The budget proposals would impose a 2-step restriction. First, investment tax credits allocated to a particular limited partner cannot exceed his at risk amount. Second, after reducing the at risk amount for the allocation of investment tax credits, a limited partner can only deduct business losses allocated to him to the extent those losses do not exceed his remaining at risk amount.

Allocated losses not deductible by a limited partner under these rules may be carried forward and deducted in a future year when there is again a sufficient amount at risk. The budget proposals apply only to losses of the partnership from business or property. A bright note for resourceful investors is that no such restriction is proposed in respect of allocations of Canadian Exploration Expense (CEE), Canadian Development Expense (CDE), or Canadian Oil and Gas Property Expense (COGPE). At-Risk Amount

The limited partner’s at-risk amount is proposed to be calculated as follows:

* the partner’s adjusted cost base of his partnership interest at the end of the year

* plus his share of the current year’s income from the partnership

* less draw-ins and all amounts owing by the partner to the partnership and less any portion that may reasonably considered to be, directly or indirectly, protected from loss

* less CEE, CDE, COGPE and foreign exploration and development expense “FEDE” incurred in the fiscal period and allocated to the limited partner. Use of leverage is restricted

Since the starting point for the calculation of the at-risk amount is the partner’s investment in the partnership, the leverage provided by debt within the partnership is automatically excluded from this amount.

Further, loans between persons dealing not at arm’s length with the partner or the partnership will be taken into account in the determination of the particular limited partner’s at-risk amount in respect of amounts owing to the partnership. For example, where a general partner of a partnership has lent money to a limited partner in order to fund that limited partner’s contribution to the partnership, the amount of that loan will reduce the limited partner’s at-risk amount.

Similarly, where an amount or benefit is made available to a person with whom a limited partner does not deal at arm’s length, the reduction of the limited partner’s at-risk amount will be required.

Except as noted below, where a limited partner has a right to exchange his partnership interest for some other property, he is considered to be entitled to an amount or benefit protecting him from loss to the extent of the fair market value of the other property at the time the at-risk amount is being computed. Exceptions

No reduction to a limited partner’s at-risk amount is required should the protection from a loss in his investment take the form of:

* normal liability insurance protection to purchase the partnership interest at any time at its fair market value at that time, or

* a buy-sell agreement relating to the partnerships interest that applies in the event of the death of the owner thereof.

Guarantees in respect of the gross revenues of a partnership normally will not be considered to be an amount or benefit protecting the partner from loss, and will therefore not reduce his at-risk amount. Specifically excluded from the rules requiring a reduction of at-risk amount are prescribed revenue guarantees for certified film productions. Second Time Purchaser

The budget proposals also deal with what happens when the limited partnership interest is acquired by a subsequent owner. For the purpose of the at-risk rules, the cost of the interest to an acquirer is to be the lesser of his actual cost and the adjusted cost base of the taxpayer from whom the partnership interest was acquired. Extended Limited Partner

The budget proposals contain a number of rules that are designed to provide an extended definition of a limited partner for which the rules will have relevance. A partner will be considered to be a limited partner, and thereby subject to the at-risk rules if, at a particular time or within three years thereafter:

* the partner’s exposure in respect of his partnership interest is limited by statutory authority

* the partner’s exposure in respect of his partnership interest is limited by contract (other than a normal contract of insurance), or

* the existence of the partner, such as a corporation formed only to hold the partnership interests, provides limited liability, or

* there is a agreement to wind- up the partnership or dispose of the partnership interest and one of the main reasons for the agreement may reasonably be considered to be to circumvent the definition of a limited partner. Transitional Rules

The budget proposals provide grandfathering protection in respect of interests in a partnership which were existing on Feb 26. If a partnership interest is considered an exempt interest, a person who would otherwise be considered to be limited partner will not be subject to the budget proposals. Basically, an exempt interest is defined at a particular time and means an interest in a partnership that was carrying on business on a regular and continuous basis on Feb 25, and continuously until that particular time.

A partnership interest can lose exempt status where, after Feb 25 there has been a substantial contribution of capital to the partnership or substantial partnership borrowings. The proposed rules introduced three specific circumstances where such contributions or borrowings will not be considered substantial These circumstances are:

* where the funds are required to fulfill contractual obligations entered into by the partnership before Feb 26

* where the funds are raised pursuant to a prospectus, preliminary prospectus, or registration statement filed with the appropriate securities authority before Feb 26, or

* where the use of the funds was for the day-to-day operation or maintenance of the business as it existed on Feb 25.

Other relieving provisions exist in respect of funds which have been raised pursuant to a prospectus filed with the appropriate authority before Feb 26. Unfortunately, no similar relieving provision exists for financings involving offering memorandas.

On Aug 21, Communications Minister MacDonald announced further transitional relief regarding the budget proposals. The budget proposals are to be modified with respect to general partnerships formed before June 12 (i.e. before the tabling of the detailed rules) to produce or acquire a Canadian film or video certified by the Department of Communications for purposes of the 100% capital cost allowance program. Impact of the Budget Proposals

It is clear the budget proposals serve notice that no longer will partnerships be able to flow out to limited partners capital cost allowance, business losses and investment tax credits in excess of their at-risk amount. Limited partnership tax shelters involving gas plants, manufacturing facilities and most franchise operations will be affected by the proposals.

For these types of investments it will no longer be possible for the investor to lever himself on a risk- free basis to enhance a yield on in
vestment as in the past. Syndicators will want to carefully consider the timing of draw-ins (which reduce the limited partners at-risk amount) to ensure deductions available to a limited partner in a particular year are not jeopardized.

In the event there is not much risk of liability for a particular project or adequate insurance can be obtained at a reasonable price, taxpayers might consider using a general partnership to avoid the negative implications of these budget proposals. Look to the bright side

It was a conscious policy decision by the Department of Finance to leave exploration limited partnerships outside the scope of the budget limitations. The budget proposals will not affect a limited partner’s ability to deduct CEE, CDE, COGPE and depletion in excess of his at-risk amount since these deductions do not form part of a business loss allocated to the limited partner. These items retain their identity and are deducted at the taxpayer’s level instead of at the partnership level.

It is only the investment tax credits and partnerships business losses (which include the costs of issuing Units in the partnership) that are to be restricted by the proposed legislation. In most exploration partnerships, the deductions potentially subject to the new at-risk rules are minor in relation to the total deductions available with respect to the investment. Mr Playfair and Mr Dent are tax partners at Clarkson Gordon, Toronto