Allocation of partnership profits found to be unreasonable
As mentioned earlier, a partnership is not a taxpayer for income tax purposes. Instead, the partners are taxed on their respective shares of the partnership income.
In most cases, the partners can agree to their allocation of income in their partnership agreement, and the CRA will respect that allocation.
However, a special rule under the Income Tax Act can apply if the partners do not deal at arm’s length – usually meaning that they are related. If their allocation of partnership income is not reasonable based on the amount of their capital contributed to the partnership and their work performed for the partnership, or any other factor that is relevant, the allocation can be changed to whatever reasonable allocation is in the circumstances.
This rule came into play in the Aquilini case. The taxpayers set up a partnership that carried on a business and had certain investments. They also set up four family trusts that were partners in the partnership. The taxpayers were the other partners. The family trusts contributed only 0.0006% of the total capital contributed to the partnership, but under the partnership agreement they were allocated 99% of the partnership income.
Not surprisingly, the CRA found that the allocation was unreasonable and allocated the partnership income to the partners based on their capital contributions to the partnership. Upon appeal, both courts upheld the CRA’s position.