When Everything Starts Looking Like A Tax Shelter… See Your Therapist Or Re-read Driedger

Few provisions of the Income Tax Act are capable of causing as much initial anxiety as Canada’s tax shelter rules.
An uninitiated practitioner who begins with the definition of “tax shelter” in subsection 237.1(1), follows the trail into the limited-recourse debt rules in section 143.2, and then works through the prescribed benefit rules in Regulation 3100 may emerge with an uncomfortable conclusion: a surprising number of perfectly ordinary commercial transactions appear to fit the statutory framework.

That conclusion is (fortunately) a sign that the rules have been misunderstood. While some parts of the rules are formulaic, they are not to be applied without ordinary principles of statutory interpretation – good old fashioned lawyering.

Historically, tax shelter legislation was not enacted to combat ordinary borrowing, ordinary investing, or ordinary tax planning. It was enacted in response to a very particular problem. During the tax shelter era of the 1970s and 1980s, Canadian and American courts and commentators frequently encountered arrangements involving enormous amounts of debt that generated tax benefits greatly exceeding the taxpayer’s genuine economic investment. Some commentators, particularly in the US, referred to this phenomenon as “confetti debt”: obligations that looked substantial on paper but represented little meaningful economic risk.

The concern was never the debt itself. Leverage is not itself a tax shelter. Leverage without economic risk can be a tax shelter.
The concern was debt that manufactured deductions, losses, basis, or tax attributes without a corresponding amount of capital genuinely at risk.

Although (to my knowledge) Canada did not adopt the phrase “confetti debt,” much of our tax shelter and limited-recourse debt legislation reflects a similar concern. The common thread running through those provisions is the attempt to prevent taxpayers from obtaining tax benefits that are disproportionate to their real economic exposure.

That historical context matters because it provides a useful reality check when interpreting the legislation.

Let’s start with an example and then come back to the statutory interpretation. Consider a taxpayer who purchases a rental property entirely with cash. In direct connection with the purchase, the taxpayer obtains a revolving interest-only line of credit equal to 95% of the property’s value, secured by the property and supported by a personal guarantee. The taxpayer then uses the borrowed funds to acquire an income-producing portfolio of marketable securities.

The taxpayer is entitled to claim capital cost allowance on the rental property of 10% on a declining balance basis. The taxpayer may also be entitled to deduct interest on the borrowing because the borrowed money has been used to acquire income-producing investments. Both of these are tax benefits.

Few serious tax practitioners would instinctively describe this as a tax shelter.

The taxpayer owns two real assets (the real estate and the portfolio of securities), owes a real debt, and bears real economic risk. There is no circular flow of funds. There is no artificial inflation of deductions based on debt that is never going to be repaid. There is no debt existing solely to create tax benefits. If either the real estate or the portfolio lose value the taxpayer suffers a real economic loss and remains liable for the very real debt.

Yet a practitioner who approaches the tax shelter rules as a mechanical exercise may begin to wonder whether the existence of depreciable property, deductible amounts, secured borrowing with no repayment schedule and limited-recourse concepts somehow transforms this arrangement into a tax shelter.

Properly interpreted, the tax shelter regime does not turn this arrangement into a tax shelter.

The reason is that the tax shelter analysis requires considerably more discipline and interpretation of the law than simply identifying deductions and debt. A proper interpretation of the rules requires one to ask a gating question: what property is being tested, and are the deductions being claimed in respect of that property?

Once that question is carefully examined, many transactions that, to some, may appear suspicious begin to look exactly what they are: ordinary commercial arrangements involving real capital, real risk, and real economic substance.

The concept of “confetti debt” provides a useful reminder that Parliament’s concern was never leverage in the abstract. The concern was leverage untethered from genuine economic exposure. Confusing the two can lead practitioners to find tax shelters where none exist.

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.