to anyone who invested in shares or debt of the R&D Tax Shelters — Past, Present and corporation, and was available to be renounced before the Future R&D was done (i.e., not dissimilar in principle to flow- through shares). So a taxpayer could purchase a debt with a principal amount of, say, $50, for cash of, say, $45. The The Past debt would immediately be ‘‘repaid’’ by delivery to the Tax shelters have been with us since the 1972 tax taxpayer of a certificate renouncing a $50 tax credit. (A wise reform. 1 In the early days, life was relatively simple — per- taxpayer would have his advisors ensure that the sonal tax shelters were partnerships (movies, aircraft), and paperwork was done properly and filed with Revenue corporate shelters were largely concerned with ‘‘surplus Canada. There are many recorded instances where this was stripping’’ (pre-1972 capital appreciation and retained not done — the result being that the taxpayer did not get earnings) or loss transfers. There were no ‘‘at-risk’’ rules, no the SRTC and the R&D company had no ongoing tax lia- leasing property rules, no equivalent to subsection 69(11), bility. This is simple fraud, with negative consequences to and, of course, no GAAR. the taxpayer, not tax evasion by the R&D corporation.) The Most of the current complexities in the Act have been taxpayer would have an immediate $5 ‘‘profit’’. The R&D introduced to correct, reduce, or minimize the scope for corporation would have $45 in cash (less very generous tax shelters. Most younger practitioners will have exper- advisor fees) and a liability to do $100 worth of R&D, or face ienced the situation where their otherwise elegant tax plan a $50 penalty under Part VIII. However, for several years has been caught by an obscure provision, buried in some there was no mechanism in place to monitor the R&D, so corner of the Act. Perhaps the worst part is having to sit in many cases, the cash was removed from the corporation through a tax history lesson, given by one of the senior tax by the promoters who promptly left the country! Since the partners — usually on Friday afternoon — as to why the pro- program was open to private corporations, it was a simple vision exists. Those who have suffered in this fashion may matter to incorporate a special purpose corporation, pro- skip the next section. duce a ‘‘business plan’’ that contemplated R&D, and go from there. Examples of these traps include subsection 83(2.1), I must confess that, in my youthful innocence, I enacted to prevent the ‘‘misuse’’ of the capital dividend advised several clients not to participate in receiving SRTCs. account; subsection 129(1.2), enacted to prevent the abuse I was convinced that there must have been a catch, tax- of the RDTOH account; the ‘‘kiddie tax’’ in section 120.4, payers would have to monitor R&D spending, and the gov- and many more. As well, the legislators have introduced ernment could not have been so stupid, could they? I was specific provisions to reduce the opportunities for tax mini- wrong. mization. Thus we have the addition of statutory ‘‘at-risk’’ rules for partnerships; the introduction of subsection 69(11) The resource rules in sections 59 and 66–66.3 of the to reduce corporate loss transfers, and, of course, separate Act have traditionally provided considerable scope for tax registration and cost reduction provisions for tax shelters in shelters. Flow-through shares are a well-known and legiti- sections 237.1 and 143.2, respectively. We have also seen mate source of financing for junior resource companies. 3 the deletion of relieving provisions such as the ‘‘preferred In former years, much more aggressive plans were beneficiary election’’ for family trusts. undertaken to deal with the ‘‘phantom income’’ problem. However, numerous tax incentives have also been For those not familiar with the issue, this was caused by introduced into the Act and, of course, these have given provincial or Crown royalties not being deductible (para- rise to arrangements to take advantage of these opportuni- graph 18(1)(m)) and the resource allowance (paragraph ties — perhaps excessively so in some circumstances. An 20(1)(v.1)), which is in lieu, being insufficient. So the respec- example of this was the MURB (multiple-unit residential tive taxable income and cash income of a producing com- building) program which was enacted for the noble pur- pany (assuming a 52% tax rate, which is on the low side for pose of stimulating the building of affordable housing. A those years) would look something like the following: certified MURB was exempt from the leasing property rules, Income and CCA could be flowed out to investors to reduce their tax purposes Cash income. After some years, it was realized that MURBs were Oil revenue $100 $100 always more expensive to own and build than identical Less: non-MURB residences. 2 resource allowance (25) Crown royalty, say (35) Taxable income 75 — The most egregious example of good intentions gone Tax @ 52% (39) Tax (39) wrong was the infamous scientific research tax credit After-tax retained (‘‘SRTC’’) program (see Part VIII of the Act). The objective earnings $ 36 After-tax cash $ 26 was to increase R&D in Canada. The result was so abusive that every con artist from Austria to Zimbabwe relocated to From the corporate perspective, the tax rate was 60% Canada to cash in on the action! (39/65), not the statutory 52%. The plan worked as follows — corporations doing R&D One way to reduce taxes was to run revenue through in Canada were entitled to a 50% tax credit. Not only was an entity that could shelter the income. If the math was the tax credit refundable, but, also, it could be renounced done right (and it always was), the entity with tax shelter would receive a fixed dollar amount of gross revenue from found in subsections 96(2.2) through 96(2.8). In addition, purchasing an interest in a producing property (a ‘‘carve- the benefits of certain tax shelters have been limited by the out’’) which it would automatically reconvey the second matchable expenditure rules (section 18.1), the computer the purchaser had received that revenue. However, in software tax shelter rules (regulation 1100(20.1)), and the order for the transaction not to be a ‘‘sham’’, there had to flow-through share rules (subsection 66(15), etc., and regu- be a real sale of an interest in a producing property, fol- lations 6202 and 6202.1). As well, the tax shelter registration lowed by a real reconveyance back to the oil company for rules in section 237.1 ensure that the CCRA is aware of a fixed fee. The sale of the interest in the producing prop- these arrangements and their participants, and the tax erty was not taxable income — it merely reduced the shelter investment rules in section 143.2 give the CCRA a vendor’s available resource tax pools, which were partially powerful weapon to limit their effectiveness. replenished on the sale back. Essentially, the participants If that was not enough, the CCRA also has available the would split the tax savings. civil penalty provisions of section 163.2. 4 To date, there are ‘‘Carve-outs’’ involved real transactions, involving the no reported cases on these provisions and I would suggest sale of a whole producing property by the resource com- that any professional who has followed the rules of their pany for a significant amount, of which part, the real fee, professional association would be unlikely to have a was paid in cash, and the much larger part for a promissory problem. Finally, of course, there is always GAAR, which note from the purchaser, which would be exactly offset on may apply if there has been an abuse/misuse (see OFSC the reconveyance of the producing property to the Holdings (2001 DTC 5471)). resource company. There was real economic risk to the resource company, which did not want to lose a major producing property if its purchaser was in financial diffi- The Present culty. An ideal credit worthy, tax-exempt purchaser was a Most tax shelters currently in vogue are variations on major pension plan. The federal government was not charitable gifting. Many prominent Canadian charities amused. Hence, Part XII of the Act. encouraged donations of art and fine wine from their Another industry sector that effectively does not pay patrons by offering generous tax receipts for the donated (and has never paid) Part I tax, that has a very high credit items, based on fair market value. Since the accepted defi- rating, is the life insurance industry. (Insurance companies’ nition of ‘‘fair market value’’ is the highest price that can be lack of income taxes is now compensated by premium obtained from a willing buyer, the charity has considerable taxes, Part XII.3 tax, and capital taxes.) So after the introduc- flexibility in issuing receipts. tion of Part XII, carve-out transactions migrated, for a time, More recently, similar plans have been promoted to to the life insurance companies. Hence Part XII.1. the general public, initially offering prospective donors art In the past, we have also had tax shelters based on at a perceived discount from the fair market value, with the yachts, weak currencies, records, and computer software. opportunity to make a profitable gift. I will illustrate how Investors in each of these shelters have faced attacks by the this works below. tax authorities. All shelters offered to individuals rely on what I call the Drabinsky Equation, 5 which can be formulated as: No history of Canadian tax shelters, however brief, 32 = 100 = 46. would be complete without a reference to movies. For almost 30 years, in various forms through numerous tech- ‘‘32’’ represents the cash the individual will pay. ‘‘46’’ is nical changes, film limited partnerships have been the tax the anticipated tax benefit (the current Ontario rate is shelter best known and used by individuals. The attitude of 46.4%). The trick in all tax shelters is to get from the ‘‘32’’ to the Canadian fiscal and revenue authorities has been the ‘‘100’’ that is necessary to generate the ‘‘46’’. ambivalent, if not schizophrenic. Now we love them, now In the first ‘‘art flips’’ as they were known, promoters we don’t. Over the years, amendments have been some- purchased art at a discount, either directly from the artists, times restrictive and then relieving. Rulings were given, then or in a distress sale, often in the United States. The art was not, and then were. (For an interesting sidebar see Mon- then sold to Canadian donors, who promptly donated to a arch Entertainment v. Strother et al. (2002 DTC 7327), charity. Because most of this art had a value in the range of which is under appeal.) There has been a continuing $1,000, the donors took the position that it was ‘‘personal- debate, far outside the scope of this commentary, on the use property’’ and accordingly, did not recognize a capital costs and benefits of sustaining the Canadian film industry gain on the disposition since the ACB and proceeds were through the tax system and what, if any, is the most appro- each $1,000. Concern about these arrangements led to the priate form of delivering such benefits. Currently, there are introduction of subsection 46(5), which denies the benefit tax credits available for Canadian expenses, and a separate of the personal-use property rule if the art donation is part regime for non-Canadian expenses that are incurred in of a plan or scheme promoted by another person. Canada. This change barely slowed down the market, which Throughout the years, the main vehicle used to pro- automatically adjusted the price of the art downward to vide tax shelter benefits to individuals, including film take into account the capital gain, giving a price for the art expenses, has been the limited partnership. The benefits of about 12% of its fair market value (see the Drabinsky Equa- such partnerships have been curtailed by the ‘‘at-risk’’ rules tion). As well, promoters realized that many commonly available goods could be purchased with a significant dis- The Future? count to retail prices. If fair market value is the ‘‘highest It is safe to predict that we will see a further tightening price’’, then such diverse commodities as educational of the rules for charitable gifts. Both the Province of Quebec products, vacation time-share properties, collectibles of all and the Canadian Cultural Property Export Review Board kinds, some food, medical supplies, certain clothes, and require donors to have owned art and similar property for many other things with a listed or established market, can two years before donating it, and perhaps similar rules will be bought at a fraction of their (downtown Toronto) retail be introduced into the Act. There is, however, a fine line price. This raises the issue as to whether there should be a that needs to be walked here, to avoid antagonizing the bulk or volume discount applied. So far, in the context of charitable sector. How do you distinguish between an ‘‘art art donations, the courts have rejected this concept in two flip’’, and a request by a charity to a long-time patron for art cases. 6 to be used in fundraising? What is the difference between a New rules for this year are tax shelter registration rules promoter’s medical supplies, and a donation of similar for ‘‘gifting arrangements’’ in section 237.1. As well, pro- items for disaster relief? Why should a donor of fine wines posed amendments to subsections 248(30)–(33) may have get a tax break, but not the donor of more common food- an impact on certain gifting structures. At first blush, one stuffs? would have thought that the introduction of tax shelter There is still legislation pending as a result of the 2003 reporting would have inhibited the incidence of gifting Federal Budget in respect of the reduction of the cost of a transactions. It seems to have had the opposite effect and gift associated with a ‘‘limited recourse’’ loan. Apparently, there appears to be more offerings than ever before! this legislation has been delayed because it ties in to the proposed amendments to subsections 248(30)–(33) It is interesting to speculate why this should be the dealing with partial gifts. case. I suggest that the explanation might include the fol- lowing reasons. As history has shown, it usually takes sev- We can look to the U.S. experience for possible eral attempts before a tax shelter is effectively closed insights of what is to come. The IRS has issued regulations down, so this may be a ‘‘last chance’’ to participate. More- concerning ‘‘abusive tax shelters’’ (do they not apply to over, any sales to corporations (which have a deduction for regular tax shelters?). As I understand it, the new U.S. rules donations) may already have been caught under the were driven, in part, because of ‘‘proprietary’’ tax plans former provisions of section 237.1 so promoters were leery developed by the ‘‘Remaining 4’’ accounting firms, and of making sales to corporations, since such transactions sold, at great expense, to large corporate clients. The U.S. might be tax shelters. Now that all transactions must be rules attempt to get more detailed information on such registered as tax shelters, the concern about selling to cor- transactions. For example, taxpayers involved in a very porations versus individuals is no longer relevant, so effec- broad range of transactions must reveal detailed informa- tively the market has been expanded. tion to the IRS, including the name of any tax advisors used and any anticipated tax benefits. The rules are worded so A variation on the gifting theme uses a Canadian trust, broadly that they will include many normal commercial established for the purpose of receiving (from a non-resi- transactions. As in Canada, there are substantial penalties dent settlor) certain property. The terms of the trust allow for failure to register. In addition, law firms, accounting distributions to beneficiaries, which show themselves firms, and other advisors must keep detailed records of inclined to charitable giving. This intention is evidenced by each transaction, which must be provided to the IRS on a pledge by the individual to donate to certain charities. request. Recently, a new set of rules was introduced in the The trust distributes property to such person, who then United States relating to ‘‘confidential transactions’’. A tax- gives the property plus cash to the charity. The advantage payer will be deemed to have entered into such a transac- of this structure is that the property is received from the tion and be required to register it as a tax shelter where trust with an ACB equal to the trust’s cost which, if the trust there are two conditions. First, if the taxpayer has received received it as a gift, is fair market value. The donors have no any tax benefit and second, if there is any confidentiality capital gain on the donation, so meeting the requirements agreement. Both tax benefit and confidentiality agreement of the Drabinsky Equation is easier. are broadly defined, so that, for example, normal deprecia- tion on an asset is a tax benefit, and a confidentiality agree- There is another form of donation structure involving ment covers any understanding, whether or not legally leveraged loans. Essentially these work by having a lender binding. lend to a donor, say $80, who donates the loaned funds plus the donor’s own $20 to a charity for a $100 receipt. Many normal commercial transactions will be subject The donor also pays fees or other charges of $12 (i.e., ‘‘32’’ to these rules, including M&A transaction negotiations with for ‘‘100’’). The charity then uses most of the donated ‘‘non-disclosure’’ arrangements. There are exceptions to funds to purchase something from an offshore party, which these rules relating to disclosure prohibited by securities arranges for the lender to be repaid. Such structures rely on legislation, but these exemptions are not available for the CCRA’s interpretation on the meaning of ‘‘gift’’ being many transactions, and the IRS has indicated that the wrong in law. The effectiveness of these transactions has exceptions will be narrowly interpreted. been severely curtailed by subjecting the debt to the ‘‘lim- In Canada, the general rule of thumb has been that tax ited recourse debt’’ rules in section 143.2. shelter sales increase as you travel west. Alberta will likely break the pattern this year, not because its citizens have feature article is a recurring monthly publication in Tax grown to love paying taxes, but primarily because, with a Topics. maximum rate of 39%, the risk/reward parameters of the Drabinsky Equation have changed. If federal tax rates con- Notes: 1 There is no entry for ‘‘Tax Shelters’’ in the Index to the publications of the tinue to decline, and the tax shelter rules become ever more complicated, we will likely see a similar phenom- Canadian Tax Foundation for the pre-1972 period. 2 The difference being essentially the discounted present value of the tax enon in the rest of the country. benefits plus promoter’s fees — an example of perfect markets in opera- Graham Turner is a tax partner in the Toronto Office tion. of Fraser Milner Casgrain LLP. Graham is also a member of 3 Unlike SRTCs, there is monitoring of the expenditures on resource explora- the Editorial Board of CCH’s Canadian Tax Reporter. tion, usually by reputable brokers. Accidents do happen, and, very occa- sionally, the funds are not spent appropriately, but such occurrences are A number of tax lawyers from Fraser Milner Casgrain very rare. LLP write the commentary for CCH’s Canadian Tax 4 For a more detailed discussion, see Brian Carr and Grace Pereira, volume Reporter and sit on its Editorial Board. Fraser Milner Cas- 48, no. 6 Canadian Tax Journal 1737-92. grain lawyers also sit on the Editorial Board and write the 5 In honour of Garth, who may or may not have invented film tax shelters. commentary for CCH’s Canadian Tax Objection and He certainly was the best-known personality involved in the early estab- Appeals Procedures reporter and have authored two lishment of the Canadian movie industry. books currently available from CCH — Corporation Capital 6 Whent (96 DTC 1594) and Malette (2003 DTC 1078). (Malette is under Tax In Canada and Canadian Transfer Pricing. The firm’s appeal).