Originally Published in Blakes Bulletin on Tax, October 2007
In 1995, the Department of Finance substantially amended the tax shelter rules under the Income Tax Act (Canada) (the Act). Until recently, they had not been considered by the Federal Court of Appeal.
The purpose of the amended tax shelter provisions, as stated in the Department of Finance’s explanatory notes accompanying the draft legislation, was to "improve the fairness of the tax system by preventing abuses through aggressive tax shelter promotions". From the date the amended legislation was introduced, there was concern that the broadly worded rules would catch more than the aggressive tax shelter promotions specifically targeted by the provisions, potentially subjecting bona fide commercial transactions to the harsh consequences of the tax shelter regime.
Pursuant to section 237.1, "promoters" and investors in a tax shelter are subject to reporting requirements, as well as potential limitations on deductions that may be claimed in respect of the tax shelter. Pursuant to subsection 237.1, a "promoter" in respect of a tax shelter means a person who in the course of a business sells, issues or promotes the sale, issuance or acquisition of the tax shelter, acts as an agent or adviser in respect of the sale, issuance, promotion or acquisition of the tax shelter or accepts consideration in respect of the tax shelter, and more than one person may be a promoter in respect of the same tax shelter. Promoters are subject to a penalty if they do not obtain a tax shelter identification number before selling property that is a tax shelter. No amount may be deducted or claimed by an investor in respect of a tax shelter unless the person files with the Minister a prescribed form containing prescribed information, including the identification number. Therefore, even an investor who did not know that his or her investment was a tax shelter would not be able to deduct or claim any amount in respect of the property until an identification number was obtained.
A tax shelter may also be subject to the tax shelter investment rules under section 143.2 of the Act. If a taxpayer has a "tax shelter investment", which includes a property that is a tax shelter, the immediate deduction of the taxpayer’s cost of property or amount of expenditure in respect of the investment may be reduced or deferred by any limited recourse amount and any "at risk" adjustments that may apply to the investment as calculated under section 143.2.
The Definition Of Tax Shelter
Subsection 237.1(1) sets up a two part test that must be satisfied in order for a property acquired to be caught by the definition of ‘tax shelter’:
- Would the amounts deductible within the first four years of acquisition of the property be equal to, or in excess of, the cost of the property as reduced by certain "prescribed benefits"?
- Were statements or representations made, or proposed to be made, in connection with the property that an acquisition of the property would result in such amounts being deductible?
The tax shelter definition illustrates the importance of the statement or representation requirement. Without the requirement, any commercial arrangement with deductions equal to or exceeding the cost of the property within the first four years of acquisition could be swept into the tax shelter regime. This concern was recognized by the Canada Revenue Agency (the CRA) in its Information Circular, IC89-4, "Tax Shelter Reporting", August 14, 1989, where it stated that "the definition of what constitutes a tax shelter depends entirely on the reasonable inferences to be drawn from representations made in connection with the property."
Surprisingly, the Federal Court of Appeal (FCA) has recently adopted an extremely broad interpretation of the statement or representation requirement in its recent decisions in The Queen v. Baxter and Maege v. The Queen.
The Maege And Baxter Decisions
In both Maege and Baxter, the issue of whether a tax shelter was acquired by the taxpayers depended on whether the statement or representation requirement in the tax shelter definition had been satisfied. The facts in Baxter were as follows. Daren Baxter along with numerous other investors, purchased a software licence for the Trafalgar Index Program (TIP), a financial trading software from Trafalgar B.V.
Mr. Baxter, a lawyer, received a package of materials with respect to the TIP licence from an independent sales agent who was marketing the licenses on behalf of TCL Trafalgar. Though the promotional package discussed the business behind the TIP, it was agreed by the parties at trial that Baxter did not receive any oral statements or representations in respect of the tax consequences of the license. Baxter paid CAD 50,000 for the licence and entered into an Agency Agreement with Trafalgar Trading Limited (TT) under which he provided the software and TT contributed CAD 10,000 of capital and used the licence to make trades on Baxter’s behalf.
Baxter claimed tax depreciation totalling CAD 50,000 based on the cost of the licence for the 1998 and 1999 taxation years. The CRA denied the deduction as, among other things, Baxter had acquired a ‘tax shelter’ within the meaning of section 237.1 which had not been registered with an identification number, and he was therefore prohibited from claiming any deduction pursuant to subsection 237.1(6) of the Act.
Following a thoughtful analysis of the tax shelter definition, the Tax Court of Canada (TCC) held that Baxter had not acquired a tax shelter – although statements and representations as to the availability of the depreciation claim regarding the cost of the licence had been made to other investors, no representations had been made to him directly.
The TCC’s decision was overturned by the FCA. The FCA adopted a broader interpretation of the statement or representation requirement and held that the appropriate test for determining whether a statement or representation had been made was whether a statement or representation had been made to "prospective purchasers". The statement or representation did not have to be made specifically to Baxter in order for Baxter’s investment to be considered a tax shelter, so long as a representation had been made to another prospective purchaser.
As in Baxter, the FCA in Maege adopted a similarly broad interpretation of the statement or representation requirement of the tax shelter definition. In Maege, the CRA denied Ms. Maege’s claims for investment tax credits and business losses arising from her participation in a partnership, Botanical Technologies, which developed botanical technology products. Ms. Maege, a professional accountant, invested in Botanical Technologies from 1989 to 1992 and claimed losses in the amount of the investments as well as her corresponding share of scientific research and experimental development (SRED) credits. Ms. Maege acted as her own tax adviser. In addition, she was responsible for communicating to other investors the tax consequences of participating in the partnership and the availability of credits for SRED expenses. Offering memoranda for the relevant tax years were provided to investors and it was not disputed that investors were told about the potential for tax losses as well as tax credits through investing in the partnership.
The TCC held that Ms. Maege had acquired a tax shelter despite the fact that no statements or representations had been made to her regarding the potential losses and credits that she would be able to claim in respect of her interest in the partnership. Rip J. held that it was irrelevant that no statements in respect of the tax deductions available with respect to her investment in the partnership were communicated to her. She expected beneficial tax consequences to arise as a result of her investment in the partnership and that was sufficient to meet the representation requirement. Furthermore, Rip J. stated that a representation is not limited to oral or written statements but also includes "a mental or intellectual element and appears to encompass a representation to one’s self."
The FCA upheld the decision of the TCC stating:
"... we agree with Rip. J, when he says that the fact that the appellant Maege did not make statements to herself is irrelevant. What is relevant is that she knew that beneficial tax consequences would arise as a result of her investment ..."
Following the Maege and Baxter decisions, it would appear that any investment that meets the mathematical formula under the definition is at risk of being considered a tax shelter given the broad interpretation of the representation requirement in both decisions. A property could be a ‘tax shelter’ where the investor "knew of the beneficial tax consequences" in respect of the property acquired, despite the fact that no representations were in fact made to him or her regarding the deductions available. Furthermore, according to Baxter, an investment by all investors to whom no statements or representations were made would become a tax shelter if a statement or representation had been made to a single investor, or potential investor. As an example of the types of commercial arrangements that could be caught by the tax shelter rules, consider this: a company constructs a manufacturing facility that is financed with a five-year mortgage amortized over 25 years. The deductions for capital cost allowance and interest expense could cause the building to qualify under the mathematical requirement as a tax shelter. Without the requirement that a representation be made to the investors in the manufacturing facility, the manufacturing facility would be a tax shelter despite the fact that the investment is bona fide and income is earned on the property.
It is certainly arguable that the Maege and Baxter decisions are inconsistent with the text, context and purpose of the tax shelter provisions and create significant uncertainty in their application. What is clear from the decisions is that investors can no longer rely on the statement or representation requirement in the tax shelter definition to protect what would otherwise be considered legitimate investments and commercial transactions from inadvertently falling under the tax shelter regime.
The final word may rest with the Supreme Court of Canada as an application for leave to appeal to the SCC has been filed in Baxter. It is hoped that the SCC take the opportunity to provide some clarity and direction in the interpretation of the tax shelter provisions, bringing the application of the rules back in line with their purpose: to isolate and address aggressive tax shelter promotions.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.