PLEASE NOTE: THIS INFORMATION WAS ORIGINALLY SUBMITTED BY COOPERS & LYBRAND, CANADA
As we approach December 31, 1997, many individuals begin their annual last-minute search for that elusive tax shelter. There is little point, however, in spending a dollar to save 50 cents of tax. Therefore, all investments should be examined for their ultimate income-earning potential. As the old adage goes, "Don't let the tax tail wag the business dog!". Moreover, investments that receive specific income tax relief are often higher risk opportunities with tax relief accorded to them to encourage investment that might otherwise not be forthcoming. Investors should be satisfied that their investment will yield returns commensurate with the associated risks.
As part of their general background research, prudent investors should investigate:
- the share of profits to be received and the reliability and reasonableness of forecasts;
- the reputation of the general partner or the group that is actually managing or controlling the investment;
- the promoter's compensation (before and after pay-out), and the promoter's record with previous tax shelters and other investment vehicles;
- the liquidity of the investment;
- the potential liability for supplying additional funds, either on account of cost overruns or for lawsuits;
- the certainty of tax write-offs (see comments below under "Tightening the Noose"); and
- where the investment is a "tax shelter", the promoter must apply for a Revenue Canada tax shelter identification number. Without it, a taxpayer will not be able to claim the benefits of the shelter. Investors in these tax shelters should note that the number does not indicate Revenue Canada's approval of the tax write-offs, it just makes Revenue Canada's audit and reassessment easier if they eventually decide to disallow some or all of the tax benefits.
Tightening The Noose
Over the last few years, the Canadian government has moved forward with a number of measures to reduce the proliferation of tax shelters marketed to investors. These include the "at risk" rules, the "limited-recourse debt" rules, the "matchable expenditure" rules, and the broadening of the "minimum tax" base. Revenue Canada has attacked numerous tax shelters disallowing tax benefits by alleging:
- a lack of business activity, or an activity with no reasonable expectation of profit;
- unreasonable or inflated expenses, or overvalued assets; or
- limited-recourse financing, including promises that debts will be forgiven or not be collected, or offers of financing arrangements that indefinitely defer an investor's payment.
Taxpayers are well advised to consider these items before purchasing any investment marketed as a tax shelter.
Many of the tax-favoured investments recently available utilized a limited partnership as the investment vehicle. In these structures, the limited partner's tax deductions and credits that can be claimed are generally limited to the amount actually invested and "at risk" in the partnership. In addition, the Alternative Minimum Tax can have an adverse impact in tax shelter arrangements.
Tax shelters acquired with limited-recourse debt will have their tax benefits curtailed. Any unpaid limited-recourse debt will not be added to the cost base of the investment, hence reducing the investor's tax deductions. Those making tax shelter investments should not ignore these rules, especially as "limited-recourse debt" is very broadly defined. The government's aim with these rules is to limit tax deductions to money which has been actually paid or borrowed on prescribed terms with bona fide repayment arrangements for all principal and interest.
The tax deferral advantage of many shelters will be curtailed by the "matchable expenditure" proposals that, in some cases, will be effective from November 18, 1996, the date first announced. The targeted shelters generally involve the financing of business expenses by selling those expenses to investors who may derive significant tax deferral benefits. The investors undertake to pay the expenses that would otherwise be payable by the "vendor" (e.g. payroll, sales commissions) in exchange for a right to receive future income. Previously, an investor could fully deduct these "purchased expenses" from income in the year they were purchased. Under the matchable expenditure rules, an investor may not fully deduct these expenses in the year purchased. Instead, these expenses will be amortized by the investor over the period of time in which the investor is entitled to receive future income from the investment (unless the term of income entitlement from the investment is less than five years, in which case the expenses must be amortized over five years). The deductibility of this amortized amount is further limited to the amount of income actually received in the year from the investment.
These matchable expenditure rules have undergone modification to their effective date in particular circumstances (e.g. film production services, mutual fund fees) and final legislation is not expected to be tabled in Parliament until later this year.
Note also that the general anti-avoidance rules (GAAR) found in the Income Tax Act empower the government to re-characterize or adjust virtually any transaction (or series of transactions) unless the transaction or series is undertaken primarily for non-tax reasons. If the transaction or series is tax-motivated, it may still be acceptable provided it does not result in abuse or misuse of the tax legislation. This is a very complex provision and professional assistance is advisable in assessing its impact on a particular tax shelter or other transaction.
The foregoing underscores the fact that governments have assiduously limited tax shelters and used a very wide general anti-avoidance net to campaign against "schemes". This is not to say that no viable shelters or tax planning techniques remain. However, the range of planning and variety of effective tax shelters has been reduced considerably, and "leading edge" tax structures must be studied very carefully indeed.
The information provided herein is for general guidance on matters of interest only. The application and impact of laws, regulations and administrative practices can vary widely, based on the specific facts involved. In addition, laws, regulations and administrative practices are continually being revised. Accordingly, this information is not intended to constitute legal, accounting, tax, investment or other professional advice or service.
While every effort has been made to ensure the information provided herein is accurate and timely, no decision should be made or action taken on the basis of this information without first consulting a Coopers & Lybrand professional. Should you have any questions concerning the information provided herein or require specific advice, please contact your Coopers & Lybrand advisor, or: David W. Steele, Coopers & Lybrand, 145 King Street West, Toronto, Ontario M5H 1V8 Canada on Fax: 1-416-941-8415 or E-mail: email@example.com
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