This article by Suzanie Chua, LLB(Hons), FCA, Barrister of Gray's Inn, Department of Justice, Tax Law Services, Ottawa, first appeared in CCH’s Tax Topics newsletter No. 1939 dated May 2009.

The dispute in this appeal (2009 DTC 5058; 2009 FCA 33) centred on the characterization of an amount received by the taxpayers in settlement of a legal action. The taxpayers were limited partners in a limited partnership that ultimately failed in its business. A civil action was commenced against the lawyers who advised the partnership. The plaintiffs consisted of the limited partnership and most but not all of the limited partners. The statement of claim pleaded the claims of the individual plaintiffs, i.e., the limited partners, as the amount of their investment in acquiring limited partnership units. In the alternative, the partnership claimed for damages of an equal amount. The partnership also claimed for damages in connection with liabilities sustained under a specific business project. Finally, the individual plaintiffs and the partnership claimed for lost profits and punitive damages. Ultimately, the case was settled out of court, by way of payment of a sum of money in trust for the individual plaintiffs.

The taxpayers took the position that the settlement payment they received was not taxable as income or gain. At the Tax Court, the trial judge applied the surrogatum principle and agreed with the Minister's reassessment that the amount was taxable as a distribution of partnership capital. The Court of Appeal overturned the trial judge's decision and held that the settlement payment could not have replaced a distribution of partnership capital because there was no change in the corpus of the partnership capital or the relative interests of the partners. An important consideration for the Court of Appeal was the fact that the payment was made by the lawyers to the individuals, and nothing was paid to or for the benefit of the partnership. Finally, the Court of Appeal concluded that the settlement payment could not be said to have replaced a distribution of partnership capital because, as a matter of law, it did not and could not have discharged any claim the limited partners had against the limited partnership, much less a claim for a distribution of partnership capital.

A partnership is a relationship between the partners that is defined by provincial law. The Ontario Partnerships Act defines a "partnership" as "the relation that subsists between persons carrying on a business in common with a view to profit …". Contrariwise, for purposes of income tax, the Income Tax Act creates a fiction that the partnership is a separate person.

It would appear that there were two distinct claims pleaded in the statement of claim in reference to the amount paid to acquire partnership units. First, the taxpayers sued for return of the amount they contributed to the partnership. It is doubtful that this claim could have been made by the partnership against the lawyer-defendants. Accordingly, the statement of claim revealed an alternative claim by the partnership, based on damages, of an equal amount. The Ontario Partnerships Act states that all property and rights and interests in property brought into the partnership, on account of the firm, or for the purposes and in the course of the partnership business, are called "partnership property", and must be held and applied by the partners exclusively for the purposes of the partnership and in accordance with the partnership agreement. Therefore, the first claim appears to relate to the time immediately before the time the taxpayer became a partner, i.e., the contribution was made in order to become a partner. The alternative claim made by the partnership for damages of an amount equal to the aggregate of the original contribution by each partner, would only arise at the time immediately after the time the individual plaintiff became a partner, i.e., at the time when the money became partnership property, within the meaning of the Ontario Partnerships Act.

For income tax purposes, subparagraph 53(2)(c)(v) is worded broadly to capture payments received by taxpayers "on account of or in lieu of payment of, or in satisfaction of" a distribution of a partner's share of partnership profits or capital. The distinction between "partnership profit" and "partnership capital" pertains to the difference between an income and a capital asset, which is recognized for tax and accounting purposes. The words in subparagraph 53(2)(c)(v) link the receipt to a partner's share of a distribution of partnership capital or profit. The Court of Appeal appears to interpret this solely from the perspective of the partnership, i.e., did facts exist such that the partnership did or could have made a distribution of profit or capital, but instead did something else "on account of or in lieu of payment of, or in satisfaction of" a distribution. On the facts, it was determined that there was no distribution of partnership capital based on prior case law. The Court of Appeal was also persuaded by the fact that the payment was made to the partners, not the partnership. Therefore, there could not have been a capital distribution. Based on this, the Court of Appeal held that the conditions in subparagraph 53(2)(c)(v) were not satisfied.

A broader read of subparagraph 53(2)(c)(v) would include a situation where the facts showed a connection between the receipt and the partner's share of a possible distribution of partnership profit or capital, regardless of whether it did not, or could not, have happened. Even if, as a matter of law, there was no, nor could there have been, a distribution of partnership profit or capital, the phrase in subparagraph 53(2)(c)(v), "on account of or in lieu of payment of, or in satisfaction of", should operate as intended to capture the receipt. The legislative language invites a liberal interpretation because it demands a re-description of the amount received in the broadest possible terms (i.e., the amount was an amount on account of or in lieu of payment of, or in satisfaction of a distribution), and the fiction of what should have occurred (i.e., instead of what happened, there should have been a distribution of partnership profit or capital), and not what did happen (i.e., there was no distribution) nor what could have happened (i.e., there could not have been a distribution). The purpose of the legislative provisions on adjustments to the adjusted cost base of partnership interest is to ensure that income (or loss) incurred by the partnership and taxed (or allowed) in the hands of the partner, can be withdrawn without further tax implications or taxed to prevent an unintended benefit. As the result in this case suggests, only a less narrow interpretation of subparagraph 53(2)(c)(v) would give effect to the legislative intent. The Crown has applied for leave to appeal.