Under the Income Tax Act (Canada) ("the Act") a limited partner ("partner") is deemed to realize a capital gain where the adjusted cost base (“ACB”) of the partner’s interest is negative at the end of the limited partnership’s year-end. This rule does not apply to interests in general partnerships, however.
In general, the ACB of a partner's limited partnership ("partnership") interest is equal to the aggregate capital contributions less withdrawals plus the partner’s share of the partnership's income for each completed fiscal period of the partnership that ended before the calculation date. The calculation of the ACB of a partnership interest at the end of the partnership's fiscal period does not include the partner’s share of the current year income. This amount is added in computing the ACB immediately after the partnership's year-end.
The fact that the partner’s share of annual partnership income is not included in the calculation of the ACB of the partnership interest until after the end of the partnership's fiscal year can result in a deemed capital gain in some fairly common situations.
In many cases, partnerships make cash distributions to partners during the year out of current earnings. These distributions reduce the ACB of a partner’s interest when they are paid but the partner's share of the partnership income for the same year is not added to the ACB of the partner's interest until the following year. This mismatch in timing could result in a negative ACB and a deemed capital gain where the ACB of the partner’s interest at the beginning of the year is less than the current year distributions.
A similar result can occur in the situation where a partnership realizes a capital gain and distributes the proceeds to the partners before the partnership's year-end. The capital gain would not be added to the ACB until after the partnership's year-end. The distributions would be deducted in calculating the ACB of a partner’s interest at the partnership’s year-end but the gain would not be added to the ACB of the partner’s interest until the first day of the next fiscal year.
It is important to consider the impact on the ACB of the partnership interest when determining the timing of distributions to partners. Often the negative consequences can be avoided by delaying the distributions until after the partnership year-end or by having the partnership advance funds to the partners as bone fide loans that are repaid by offsetting capital distributions after the year end, when the ACB of the partners' interests have been increased by the year-end earnings.
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