The recent decision of Canada’s Federal Court of Appeal (the “FCA”) in The Queen v. Green et al., 2017 FCA 107, highlights the tax effectiveness of tiered partnership structures, and suggests significant potential tax planning opportunities.

By way of background, under the law of Canada’s common law jurisdictions, a partnership is the relationship that subsists between persons carrying on a business in common with a view to profit; a partnership is not a person. A partnership’s lack of legal identity is reflected in the Income Tax Act (Canada) (the “ITA”); it does not pay tax, but allocates its income to its partners. The income so allocated retains its character in the hands of the partners. Consequently, a partnership is treated as a “pass-through” entity for Canadian income tax purposes. As a result, a partnership is generally not considered to be a “taxpayer” for purposes of the ITA, other than for the purpose of computing the income of its members.

In the case of a limited partnership, the “at-risk” rules, in very general terms, prevent a limited partner from claiming its allocated share of the partnership’s loss in excess of the partner’s amount “at-risk” in the partnership. A “taxpayer” is entitled to carry forward to the non-deductible loss and claim it in a subsequent period when its at-risk amount is increased.

Green involved a challenge to the Canada Revenue Agency’s long-standing administrative position that, in a tiered partnership structure where one partnership (the top-tier partnership) is a member of a limited partnership (the bottom-tier partnership), the members of the top-tier partnership are prohibited from carrying forward their respective shares of limited partnership losses of the bottom-tier partnership from previous periods. In very general terms, the Crown’s position was that: (i) in a tiered-partnership structure, the losses allocated by the bottom-tier partnership to the top-tier partnership are limited partnership losses of the top-tier partnership, but (ii) since the top-tier partnership is not a taxpayer, the rule which allows a taxpayer to deduct limited partnership losses realized in a previous period does not apply. Consequently, the losses of the bottom-tier partnership become “trapped” in the top-tier partnership.

The FCA determined that the at-risk rules which restrict the deductibility of losses of a limited partnership to its members only apply to a taxpayer, and do not apply to a limited partner that is itself a partnership. As a result, in a tiered-partnership structure, the business loss of a bottom-tier partnership retains its character as a business loss when it flows up to the top-tier partnership, which can allocate the business loss to its members.

The implications of this decision are significant. It confirms that investors in a tiered-partnership structure are permitted to access limited partnership losses of a bottom-tier partnership. Moreover, the FCA expressly acknowledged that its decision suggests that a taxpayer can circumvent the at-risk rules by interposing a general partnership (to which the at-risk rules do not apply) as a limited partner of an operating limited partnership. The FCA also noted the possibility that losses incurred by one limited partnership could be claimed against the income from another limited partnership. The court suggested that tax avoidance concerns could be addressed by way of legislative amendment, or, depending on the particular circumstances, via the application of the general anti-avoidance rule in section 245 of the ITA.