In Backman v. Canada, the courts communicated important rulings regarding valid partnerships. Specifically, this case helped outline what constitutes a valid partnership, what basic functions of a partnership should be present, and an example of a situation where a valid partnership was not formed.
The appellants bought a partnership interest in an apartment construction venture. Immediately after buying their ownership shares, they sold their partnership interest back to the previous owners. An important note of this resale is the dollar amount; the appellants’ sale back to the original owner was for substantially less than their purchase price. This created millions of dollars of accounting losses potentially deductible as partnership losses that could offset other taxable income from the current year.
The conflict in this case surrounds the validity of the partnership created with the appellants’ purchase and resale of their partnership interest. If their purchase did constitute a valid partnership, they would be allowed to deduct the losses created by the resale of their interest. Otherwise, an invalid partnership agreement would leave the investors with millions of dollars of undeductible losses. A second issue related to the assignment of an interest in a partnership. If the appellants took an assigned interest in the partnership, could this fulfill enough criteria to be considered a valid partnership?
The Supreme Court of Canada ruled the appellants did not satisfy the definition of a partnership. This ruling meant the appellants could not deduct the losses. Plus, the courts did not accept the argument that an assigned interest in a valid partnership constituted a valid partnership.
The Supreme Court of Canada spent time in its ruling to explain basic criteria required for a valid partnership to be present. It outlined the essential elements that make up a valid partnership. One of the requirements is to have a view to make a profit. The idea to have a view of making a profit means the parties join in a common goal to make money. Because there was no intention to make money in this situation, the validity of the partnership was denied.
Residual Impact and Findings
Backman v. Canada communicated important findings that impact the work of accountants. The most direct impact was on what it means to be a partnership. For a valid partnership to be formed in Canada, the partnership must be a business carried on in common with a view to profit. The court also defined what it meant to carry on a business. A valid partnership must extend itself to others in an attempt to sell goods or services. Through your work with partnerships, evaluate the interactions your clients have with external parties.
The court clarified by stating that a partnership doesn’t need to hold meetings, make decisions, or incur transactions. It ruled that a partnership can be formed for a single transaction as long as it does not result in an empty shell. This means your clients must have at least one financial transaction of substance. This transaction, the court ruled, could even be passive. Accepting rent revenue, which requires no interaction from the business itself other than to collect payments, constitutes business activity as the company still assumes risk and obligations.
An easy way to test the validity of your client’s legal formation is to look into its rights, obligations, and contributions to the partnership. The courts stated that valid partnerships typically have agreements that outline the rights of each party. Valid partnerships also present themselves as partners to others, contribute skills or knowledge for a common goal, share in profits or losses, file tax returns as a partnership, and may have a joint bank account. As you assist clients in forming their businesses, consider the implications of not fulfilling any of these facets of a business. Because these are fairly basic requirements and may occur naturally during the startup of a valid partnership, be aware if any of these conditions don’t occur.
Communicating With Clients
As you help your clients form partnerships, use Backman v. Canada to lay some important ground rules. First, emphasize the importance of retaining documentation, including internal and external communication, to establish the intention of a partnership. This documentation includes
a set of financial statements that are processed on a timely and recurring basis. It also includes retaining documentation on the rights and obligations of each person in the partnership.
There are other basic ways your clients can demonstrate they have a valid partnership. They must be engaged in selling goods or services. They also should file their tax return as a partnership. Although the act of holding meetings doesn’t make a partnership valid, the act of engaging in business conversations with external parties is strong evidence in your clients’ favor. Performing basic functions of a business such as opening a joint bank account always strengthen the validity of the business.
Point out to your clients that the final ruling from the courts in this case involved remedies against invalid partnerships. Third parties have certain rights against parties that incorrectly portray themselves as valid partnerships. Therefore, it’s critical your clients understand what makes a partnership valid and how to substantiate their business if necessary.