David Rotfleisch on How Limited Partnerships Are Taxed in Canada: Insights, Advantages & Drawbacks From a Canadian Tax Lawyer

An Overview of Limited Partnerships

In Canada, a limited partnership (LP) is a specialized business structure designed for two or more individuals or entities seeking to earn profit through a shared venture. Established under provincial statutes such as Ontario’s Limited Partnerships Act, an LP blends the active management of a general partner with the passive investment of one or more limited partners, as outlined in a formal partnership agreement. Though less common than corporations, LPs are often chosen for their favourable tax treatment as flow-through entities, providing significant advantages for ventures anticipating early losses or requiring flexible tax planning.

An LP must include at least one general partner, responsible for managing operations and bearing unlimited liability for debts, and one limited partner, whose liability is restricted to the amount of their contribution—so long as they refrain from participating in management activities.

In most cases, the general partner in a limited partnership is a corporation, which helps protect its shareholders from personal liability, while limited partners—who may be individuals or corporations—serve primarily as passive investors. The limited partnership agreement governs the relationship between partners, defining rights, responsibilities, capital contributions, and the distribution of profits and losses. This agreement is essential for ensuring both legal protection and operational clarity.

The general partner faces unlimited liability, whereas the limited partners remain protected as long as they do not engage in managing the business. The definition of this limit varies by province:

• Ontario, Alberta, and Saskatchewan: A limited partner forfeits liability protection if they exercise “control” over the business.
• British Columbia: The protection ends if a limited partner “takes part in management.”
• Manitoba: Provides more flexibility, allowing limited partners to offer advice on management matters without losing their limited liability.

Crossing these boundaries can cause a limited partner to be reclassified as a general partner, thereby becoming personally liable for all of the partnership’s debts and obligations.

Unlike corporations, which are treated as separate legal entities, limited partnerships are not independent taxpayers. Instead, income and losses “flow through” to the partners, who report them on their own tax returns. This flow-through treatment differentiates LPs from corporations and makes them especially attractive in situations where tax flexibility or early-stage losses are expected.

Tax Treatment Explained: The Benefit of Flow-Through Status

The primary tax advantage of an LP is its flow-through structure. An LP does not pay income tax at the entity level; instead, its income, losses, capital gains, and other tax attributes “flow through” directly to the partners, who report them on their personal or corporate tax returns. This differs from corporations, where profits are taxed at the corporate level and shareholders only report income when they receive dividends or realize capital gains upon selling shares.

• Income Character Preservation: The nature of the income earned by the LP—such as business income, interest, dividends, or capital gains—retains its character when allocated to partners. For example, a capital gain earned by the LP remains a capital gain for the partner, potentially qualifying for preferential tax treatment such as the lifetime capital gains exemption.
• Loss Utilization: Losses also flow through annually, allowing partners to offset them against other sources of income (e.g., employment or investment income). This makes LPs particularly appealing for businesses expecting early-stage losses, such as startups or real estate ventures, since investors can apply these losses to reduce their overall tax burden—something corporate shareholders cannot do.
• Restrictions for Limited Partners: The Income Tax Act (Canada) imposes “at-risk” rules (Sections 96(2.1)–(2.2)), which restrict the losses a limited partner can claim to their “at-risk amount”—generally their investment minus any prior losses claimed. Losses exceeding this amount are deferred until the partner’s at-risk amount increases, ensuring that deductions do not exceed the actual financial exposure of the partner.

Canadian Tax Filing and Non-Resident Requirements

An LP is generally not obligated to file a Canadian information return if it meets all the following conditions: it has no Canadian-source income, no Canadian-resident partners, does not conduct or solicit business in Canada, and is managed entirely outside the country. However, an LP that operates in Canada—or a Canadian LP with foreign or domestic investments or activities must file Form T5013 Statement of Partnership Income for each fiscal period if any of the following apply:

• At the end of the fiscal year, the partnership’s combined total of revenues and expenses (absolute values) exceeds $2 million, or it holds more than $5 million in assets;
• During the fiscal period:
  • The partnership is part of a tiered structure—meaning it either has another partnership as a partner or is itself a partner in another partnership;
  • The partnership includes a corporation or trust among its partners;
  • The partnership has purchased flow-through shares from a principal business corporation that incurred Canadian resource expenses and allocated those expenses to the partnership;
  • The Minister of National Revenue has formally requested in writing that the partnership file Form T5013, Statement of Partnership Income.

Non-resident limited partners who earn Canadian-source income may be subject to Part XIII withholding tax, generally set at 25% but often reduced under an applicable tax treaty. This adds complexity to cross-border tax planning. Moreover, the partnership itself can be held liable for any unremitted withholding tax that should have been paid to the CRA. If your partnership includes a non-resident partner, it is strongly recommended to seek guidance from an experienced Canadian tax lawyer to ensure all withholding and remittance obligations are properly met.

Additionally, because partnership income flows through to partners whether or not it is actually distributed, limited partners may face tax liability on their share of income they have not received—commonly known as “phantom income.” To prevent this issue, it is crucial that the limited partnership agreement aligns income allocation with cash distribution policies, ensuring partners are not taxed on income without corresponding cash flow.

Tax Pro Tips: Why Opt for a Limited Partnership?

LPs are not a default structure—they are typically chosen for their strategic tax advantages. Their ability to pass losses directly to investors makes them particularly appealing for ventures expecting early-stage losses, such as resource exploration, real estate development, or film and software production. Unlike corporations, where losses remain within the entity, LPs allow partners to claim these losses immediately, improving cash flow and personal tax planning. Moreover, since LPs are not subject to corporate-level tax, they avoid the double taxation associated with dividends, offering an edge for high-income investors seeking tax-efficient structures.

That said, LPs come with inherent risks. The general partner’s unlimited liability—often mitigated by using a corporation as the general partner—and the possibility of limited partners being taxed on undistributed (phantom) income demand careful structuring. Additionally, the complexity of Canadian tax rules, especially those affecting non-residents or partners subject to at-risk limitations, can pose compliance challenges.

To fully benefit from this structure while minimizing exposure, it is essential to have a comprehensive limited partnership agreement and a strong grasp of both provincial regulations and federal tax laws. Engaging a skilled Canadian tax lawyer ensures that the partnership is properly structured, compliant, and tax-efficient.

Frequently Asked Questions (FAQs)

What potential risks come with forming a limited partnership?

A key risk is that the Canada Revenue Agency (CRA) may deny partnership losses if it determines that the partnership functions as a tax shelter. Tax shelters are typically investment arrangements designed primarily—or even secondarily—to reduce taxes, and such structures are frequently challenged by the CRA.

The CRA has publicly stated that it is conducting criminal investigations into various tax shelter promoters. Because limited partnerships allow income and losses to flow through to partners, enabling deductions on business or capital accounts, the CRA pays close attention to these arrangements to ensure they are legitimate and not primarily for tax avoidance.

To mitigate this risk, it’s essential to evaluate early on whether your partnership could be viewed as a tax shelter. Consulting an experienced Canadian tax lawyer can help ensure your structure is compliant and defensible. Otherwise, if the CRA later disallows the partnership losses, you could face costly consequences—including legal fees, interest, and penalties.

How are limited partnerships treated for GST/HST purposes?

Under the Excise Tax Act, a limited partnership is considered a separate “person” for GST/HST purposes. If the partnership’s taxable supplies from commercial activities exceed $30,000 annually, it is required to:

• Register for GST/HST, and
• File GST34 returns — either monthly, quarterly, or annually, depending on its revenue level.

Disclaimer: This article is intended for general informational purposes only and reflects the law as of the date of posting. It has not been updated and may no longer be current. The content does not constitute legal advice and should not be relied upon as such. Each tax situation is unique and may differ from the examples discussed. For advice tailored to your circumstances, you should consult a qualified Canadian tax lawyer.

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