- TAX SHELTER ISSUES – KEY POINTS TO WATCH FOR
- LIANG V. THE QUEEN IS A CRUCIAL CASE FOR UNDERSTANDING THE LIMITATIONS OF TAX SHELTERS
- BUDGET 2023 – INTERESTING PROPOSALS AND POTENTIAL TAX INCREASES
- TAX-FREE FIRST HOME SAVINGS ACCOUNT – $40K LIMIT – FHSA TAKES EFFECT ON APRIL 1, 2023
TAX SHELTER ISSUES – KEY POINTS TO WATCH FOR
Tax shelters are the stuff of legends. They are often publicized in the media as providing tax evasion strategies for the extraordinarily rich. On the other hand, the illegitimate use of tax law in tax shelters inevitably runs afoul of the general anti-avoidance rule (GAAR), which is designed to bring out to light such behaviour; it also earns the wrath of the CRA and the public at large.
GAAR revisited
The GAAR was enacted in 1987 to combat abusive tax avoidance transactions and arrangements which technically complied with Income Tax Act. The GAAR is meant to stop such abusive practices, which cut into the CRA’s tax revenue. GAAR discussions can consume reams of paper. Suffice to say that you can comply with the GAAR by conducting bona fide transactions with a legitimate business objective in mind. If your primary objective is simply to avoid tax, and the transactions do not have any business purpose, you are on the road to a GAAR violation. The GAAR can easily be applied to tax shelters, so here are some general principles to keep in mind.
First, tax shelters are actually legal in various taxation systems worldwide. This is because, despite the various negative connotations associated with them, tax shelters serve a particularly important function: to minimize tax liabilities effectively and legally, often so that the recipient can use the funds for productive, income-earning business ventures or to support a worthwhile social cause. Registered retirement savings plans (RRSPs) are a case in point. Effective utilization of RRSPs enable millions of Canadians to avoid higher marginal tax rates during their prime earning years while using the invested funds to save for their retirement years. RRSPs serve as an important pension plan for Canadians and are a valid use of a tax shelter.
Mass-market tax shelter schemes do not work!
When done legally, tax shelters can be quite effective. A crucial issue is to demystify tax shelters. Dodgy promoters often market tax shelters to unsuspecting customers with novel ideas such as giving receipts for much higher amounts than were actually contributed. According to CRA’s own website, every one of these nebulous schemes has been found non-compliant with the Income Tax Act. Inevitably, unsuspecting clients suffer the worst of the fallout, having to pay the taxes due plus interest and penalties.
Example: Person A goes to a marketer of a lucrative tax scheme. The promoter promises Aa $10K tax receipt if A makes a donation in kind worth $200. The promoter can assign a value of $10K to the donated article, and A can claim a charitable contribution tax credit on his tax return. The promoter assures A that the tax scheme is registered, and the promoter may even have a business number and a head office location. The promoter also informs A that many clients have utilized this service to get large tax refunds, and if the CRA contests the claim, the promoter will support A through litigation.
This is a fairly typical story, and the end is painful. When all is said and done, Person A is the one who gets assessed taxes plus penalties plus interest. The cost is greater than the benefit. Don’t fall for this scheme!
LIANG V. THE QUEEN IS A CRUCIAL CASE FOR UNDERSTANDING THE LIMITATIONS OF TAX SHELTERS
A crucial case for any discussion of tax shelters is Liang v. The Queen, which was decided on June 7, 2022. This case involves some of the primary issues relating to tax shelters, including the mathematical calculation that forms basis of tax shelters, eligibility for business loss deductions, and penalties associated with false statements. Not only is this case important for educating readers on the basics of tax shelters, but it also serves as a cautionary tale for readers who fail to use tax shelters effectively and are reluctant to consult professionals when setting them up.
Background
When he retired, Billy Liang created a company called Pony Pictures Inc., which he set up ostensibly to pursue an interest in filmmaking. Pony applied for a tax shelter identification number pursuant to section 237.1(2) of the Income Tax Act.
Crucial point: Registering for a tax shelter identification number under section 237.1(2) is an administrative matter; it does not validate the tax shelter, as the Appellant learned to his chagrin in this case!
Mr. Liang withdrew $30K from his registered retirement income fund (RRIF) each year for 13 years and invested the funds in a professional financial management company, despite the funds being earmarked for Pony’s expenditure. If funds were earmarked for Pony, they should have been used for Pony’s operations, but they were not. Pony filed Form T5004 “Claim for Tax Shelter Loss or Deductions” in the amount of $30K for each of the 13 years. In addition, Pony filed Form T5003 “Statement of Tax Shelter Information” indicating a loss of $30K for each taxation year.
In computing his taxation income for each of these years, Mr. Liang claimed $30K as Other Deductions on line 232 of his tax return. Since its inception, Pony never made any movies or made any substantial progress in starting production of a film. In effect, the tax shelter was being utilized to shield Mr. Liang’s mandatory RRIF withdrawals from taxation.
Penalties levied and appeal denied
Accordingly, the CRA reviewed Mr. Liang’s tax returns and disallowed his Other Deductions. The CRA, on behalf of the Minister concerned, levied penalties against Mr. Liang pursuant to section 163(2) of the Income Tax Act for knowingly making a false statement or omission in his tax returns. The case went before the Tax Court of Canada with Mr. Liang as the Appellant, and his appeal of the penalties was dismissed.
Issues
The Court addressed four key issues in this case, and they will be relevant to all readers of this article, since such loose shelter schemes abound.
1. Was the Appellant entitled to deduct $30K as Other Deductions for each taxation year?
2. Was the Appellant entitled to claim the business losses/expenses that he made for each of the taxation years?
3. Did the Minister properly assess the Appellant for the 2014 taxation period beyond the normal reassessment period, pursuant to section 152(4) of the Act?
4. Did the Minister properly assess penalties for gross negligence pursuant to section 163(2) of the Act for the taxation years?
Question 1: Tax shelter: Was the Appellant entitled to deduct $30K as Other Deductions for each taxation year?
To answer the question, the Court analyzed the validity of the tax shelter. What constitutes a valid “tax shelter” is set out in section 237.1 of the Act. For brevity purposes, we have not included the entire definition, but we will paraphrase and clarify its meaning below.
Paraphrased quote for brevity purposes:
“Tax shelter” means
(b) … a property (including any right to income) … in respect of which it can reasonably be considered, having regard to statements or representations made or proposed to be made in connection with … the property, that, if a person were to … acquire an interest in the property, at the end of a particular taxation year that ends within four years after the day on which … the interest is acquired.”
A great simple description of a tax shelter is provided in another important judgement, Paletta v. The Queen (para. 254). In it, Justice Hogan held that the following conditions must be satisfied for a property to be considered a tax shelter:
i. There must be a property in respect of which statements and representations are made or proposed to be made;
Analysis: A property (some sort of asset) must be referenced in a tax shelter.
ii. The statements and representations must be made by a “promoter”;
Analysis: The statements and representations must be made by a “promoter.” The CRA provides a definition of a “promoter.” It is a tax shelter promoter who in the course of business
(1) sells, issues, or promotes the sale, issuance, or acquisition of the tax shelter
(2) acts as an agent or advisor for these activities
(3) accepts some sort of consideration for the tax shelter as either a principal or an agent.
A person who is engaged in these promotional activities to sell a tax shelter and receives a consideration is a “promoter,” and this individual must be the one making any representations and statements.
iii. It must be reasonable to consider, having regard to the statements or representations, that there is an amount that is represented to be deductible in respect of the property; and
Analysis: There is a reasonable amount that is deductible in respect of the property. Therefore, this would not be an outlandish amount that would not make any business sense if one were to hold the property.
iv. The amount represented to be deductible must exceed or be equal to the investor’s cost in the property less “prescribed benefits”.
Analysis: The amount deductible must be greater than or equal to the property’s costs less its associated benefits, which is the genesis for claiming the deduction.
Mathematical calculation
A crucial point the Tax Court noted regarding tax shelters was the mathematical calculation.
The Appellant withdrew $30K from his RRIF every year and claimed it as Other Deductions. Thus, the cost of acquiring the tax-shelter property was $30K each year. The amount by which losses, deductions or tax credits exceeded this $30K cost minus prescribed benefits was zero.
If the tax shelter losses or deductions do not exceed the cost of the tax shelter minus the prescribed property, then the losses or deductions cannot be claimed!
Conclusion of tax shelter definition
At the end of any taxation year that ends within four years after the acquisition of the property by the purchaser, the purchaser can deduct from his/her income an amount that would be greater than or equal to the acquisition cost of the property at the end of the taxation year less prescribed benefits. This description rules out flow-through shares arrangements or certain prescribed properties.
Question 2: Was the Appellant entitled to claim the business losses/expenses that he did for each of the taxation years?
To answer this question, the Court followed the two-step process confirmed by the Supreme Court of Canada for determining business loss deductibility:
a. Is the activity undertaken in pursuit of profit, or is it a personal endeavour?
b. If it is not a personal endeavour, is the source of the income a business or property?
For (a), the Tax Court assessed whether a source of income existed. There was hardly any income, so Mr. Liang failed step one. Since he could not prove that his activities were undertaken in pursuit of profit, his business losses were disallowed.
Note: The two-step process is the criteria used to determine business loss deductibility. If you are claiming business losses, make sure you pass this test. While it is a two-step test, the first part is crucial and is often where people fail to prove their case, as their argument that they are pursuing profit is found to be deficient, and the activities are labelled a personal pursuit.
Question 3: Did the Minister properly assess the Appellant for the 2014 taxation period beyond the normal reassessment period, pursuant to section 152(4) of the Act?
This is an important question. It relates to taxpayers’ commonly held belief that the CRA can only audit the three previous years. This is correct, except for the following important exemption, which is especially important for readers to note.
This means that if the Minister can prove that the misrepresentation was attributable to neglect, carelessness, or willing conduct, then the Minister can override the normal reassessment period and assess prior years beyond the normal three-year reassessment period. Do not take too much comfort in the three-year time period!
In this case, the Judge ruled that Mr. Liang clearly misrepresented his situation, and that his expenses were clearly not of a business nature for a variety of distinct reasons, and thus the CRA was justified in going beyond the normal reassessment period. In his assessment, the Judge considered relevant facts in the case, finding Mr. Liang to be an intelligent man who had researched tax shelters. However, if the reverse were true and Mr. Liang was found not to have been intelligent, that too may not have been a valid defence, as carelessness and neglect are also included in section 152(4).
Question 4: Did the Minister properly assess penalties for gross negligence pursuant to section 163(2) of the Act for the taxation years?
Section 163(2) of the Income Tax Act allows the Minister to assess gross negligence penalties if a person knowingly or under circumstances amounting to gross negligence made, participated, assented or acquiesced in making false statements or omissions in his/her return.
In this case, it was clear to the Judge, on a balance of probabilities, that the Appellant was using the tax shelter to shield his mandatory RRIF withdrawals, and therefore he dismissed the appeal.
Overall conclusions
1. A tax shelter identification number does not confer legitimacy on a tax shelter. It is best to consult with professionals, accountants, and lawyers when setting up a tax shelter. This advice should be independent of the promoter, who will have a biased interest in selling the tax shelter.
2. A proper tax shelter must satisfy a number of criteria. It is not easy to set one up, so it should be done carefully, with an understanding of the relevant rules and consequences, and with professional advice!
3. The CRA can go beyond the three-year reassessment period if it believes the person has shown neglect, carelessness, or wilful misrepresentation.
4. On a balance of probabilities, the Minister can assess penalties for gross negligence or false statements or omissions. This just makes it easier for the CRA to assess penalties. It is an illusion to think that you have to be proven guilty beyond a reasonable doubt; this is not criminal law.
BUDGET 2023 – INTERESTING PROPOSALS AND POTENTIAL TAX INCREASES
Federal government budgets over the years have had some key common traits: loss of brevity and increasing amounts of detail for the public (despite all the focus on openness, hardly anyone aside from industry experts reads the Budget, and a more voluminous budget makes it even more daunting to tackle). Here is a recap of the salient tax topics addressed in the 270-page budget document.
Alternative minimum tax (AMT) – rate increases – more taxes to pay
In the proposed Budget, the alternative minimum tax rate will increase from 15% to 20.5%, while the minimum threshold under which AMT applies will increase from $40K to $173K. These changes should come into effect starting January 1st, 2024. The AMT was introduced by the federal government to ensure that wealthy individuals who could use specific tax credits and deductions to limit tax on their applicable income would have to pay a minimum effective tax rate on their yearly income regardless. The increase in the AMT rate and the increase in the threshold will mean wealthier Canadians with access to tax preferences that can reduce their tax liabilities for the year will have to pay more tax.
It should be noted that the AMT may be recovered against the regular tax payable by taxpayers in the seven years following the year in which the AMT applied.
General anti-avoidance rule (GAAR) strengthened
An explanation of the GAAR and its applicability was provided earlier in this article. The GAAR is very broad and pervasive, and it applies to most transactions that are carried out to avoid taxes and that lack a valid business purposes. Courts have often sided with the CRA in GAAR cases. The Budget contains a proposal to start a process of consulting on and further fireproofing the GAAR. This will make it very difficult to utilize creative tax schemes (details to follow).
RESP withdrawal increase!
Good news for students! Yearly limits on RESP withdrawals since March 28th, 2023, are being increased to $8K for full-time students and $4K for part-time students in specific situations. This will make post-secondary education with its escalating tuition and associated costs more affordable for the average Canadian.
TAX-FREE FIRST HOME SAVINGS ACCOUNT – $40K LIMIT – FHSA TAKES EFFECT ON APRIL 1, 2023
To counter the scourge of increasing house prices, the federal government has introduced a new program (the FHSA), which combines elements from the Registered Retirement Savings Plan (RRSP) and from the Tax-Free Savings Account (TFSA). Under the terms and conditions, a taxpayer between the ages of 18 and 71 who did not own a home in the previous year as well as the last four calendar years will be able to open a FHSA and contribute an annual amount of $8,000 up to a cumulative maximum of $40,000. Contributions made will be deductible in computing net income as in the case with RRSP contributions. When withdrawing funds for the purchase of a home, as with the TFSA, the amount withdrawn will not be taxed. The best aspects of the TFSA and also the RRSP are reflected in this rather creative program, as a savings vehicle to help young Canadians buy a home. It should be noted that this program must be clearly distinguished from the Home Buyers’ Plan (HBP) provided for in an RRSP. The two regimes cannot be used simultaneously. In addition, unlike the RRSP Home Buyers’ Plan where funds are borrowed from the RRSP, it will not be mandatory to repay the RRSP the funds paid into a FHSA program.
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This letter summarizes recent tax developments and tax planning opportunities; however, we recommend that you consult with an expert before embarking on any of the suggestions in this newsletter that are appropriate to your own specific requirements.
