Depending on your age, you may remember the Pyramid Game Show: without stating certain key words, one person tried to communicate a concept sufficiently to allow another person to understand and identify the concept.
What does the Pyramid Game Show have to do with the tax shelter definition?
A key component of the tax shelter definition in subsection 237.1(1) of the Income Tax Act (ITA) is whether certain information is communicated (or proposed to be communicated) about property offered for sale. Specifically, the definition requires that the communication explain the tax benefits a taxpayer would receive if the taxpayer were to purchase the property. The property is a tax shelter if the communication explains that, within four years after the purchase of the property, the tax benefits will equal or exceed the purchaser’s cost to acquire the property. When a property is a tax shelter, the ITA restricts the purchaser from enjoying the tax benefits (for example, capital cost allowance (CCA) or losses) unless the seller of the property has applied for, and the Canada Revenue Agency (CRA) has issued, a tax shelter registration number. However, will property be a tax shelter if the communications merely provide sufficient detail to allow a potential purchaser to understand the tax benefits without expressly setting out or quantifying what the tax benefits are?
This is the question that the Tax Court of Canada (TCC) faced in Krumm v. The Queen (2020 TCC 7). In Krumm, a vendor communicated certain information about a property to a purchaser but did not specifically quantify the tax benefits the purchaser would receive. As a result, the TCC had to determine whether the information the vendor communicated to the purchaser was sufficient to cause the property to be a tax shelter notwithstanding that the vendor avoided key words about the tax benefits. This was the first time the TCC considered this issue and the TCC’s decision confirming that the property in Krumm was a tax shelter clarifies that the Courts will give a broad interpretation to the phrase “amount represented to be deductible” in the tax shelter definition.
In August 1997, James Krumm (Krumm) purchased a 50% interest in a computer application software from Intersports Acceleration Corp. (Intersports) for $2.8 million. The transaction was a private transaction, as Intersports did not publicly market its potential sale of interests in the software.
Prior to Krumm’s purchase of the software, Intersports secured a valuation of the software. In addition to valuing the software, the valuation report identified that the software:
- qualified as a Class 12 asset under the ITA and the Income Tax Regulations (Regulations), and
- was commercially available for use for the purposes of the ITA and the Regulations.
A taxpayer can claim CCA at a rate of 100% on a Class 12 asset (the rate is restricted to 50% in the year the taxpayer acquires the Class 12 asset). However, if the asset is not ‘available for use’ as defined in the ITA, the taxpayer is restricted from claiming CCA. As a result, the valuation report provided two key pieces of information that would allow Krumm to understand that he would be able to claim CCA of $2.8 million within two years.
In each of the 1997 and 1998 tax years, Krumm claimed CCA of $1.4 million related to the software, effectively deducting the full purchase price of the software from his taxable income over the two year period.
The CRA disallowed Krumm’s CCA claims on the basis that his purchase of the interest in the software was an unregistered tax shelter. The failure to register the tax shelter meant that Krumm was not entitled to claim the CCA.
The Tax Court of Canada
Krumm argued that the software was not a tax shelter for two reasons:
- The tax shelter rules were intended to apply to publicly marketed tax shelters and not private transactions between two parties (Krumm cited the CRA’s publications as support).
- Krumm did not understand the valuation report and was unaware of the tax deductions that could be received upon purchase of the asset and, therefore, did not rely on the information communicated in the valuation report when evaluating whether to purchase the software.
The TCC easily dismissed these two arguments. First, the TCC identified that the tax shelter definition does not state that it only applies to publicly-marketed transactions. Without such an express restriction in the legislation, there was no reason to limit the scope of the tax shelter definition to publicly marketed transactions, regardless of the CRA’s published position.
Second, the prior jurisprudence has firmly established that the purchaser’s knowledge of the tax deductions is not relevant in determining whether the property is a tax shelter. Property either is or is not a tax shelter before a taxpayer purchases the property and even if no taxpayer purchases the property. As a result, the subjective knowledge of any actual purchaser is irrelevant.
The more interesting issue that the TCC addressed was whether the communication in the valuation report was sufficient to satisfy the communication element of the tax shelter definition. Again, the tax shelter definition provides that property is a tax shelter when the communications represent that the tax benefits a purchaser will enjoy will equal or exceed the purchaser’s cost of the property within four years. Importantly, the ITA requires that this analysis be an objective analysis. As set out above, in Krumm the valuation report described the tax attributes of the software (that it qualified as a Class 12 asset and was commercially available for use), but did not expressly communicate the quantum of tax deductions that would be available for a Class 12 asset that was commercially available for use. In all previous tax shelter cases, the communications expressly set out the amount that a purchaser would be able to deduct or the tax benefit the purchaser would receive.
As a result, in Krumm, the TCC had to determine whether, for the purpose of the tax shelter definition, generally describing the tax attributes was akin to quantifying the tax benefits. In this case, the TCC held that it was. Specifically, the TCC held that, when objectively considering the description of the software’s tax attributes, there was sufficient detail for a potential purchaser to understand that the purchaser could deduct the full purchase price within two years. Avoiding specific communications about the amount of available deductions did not prevent the software from being a tax shelter.
Krumm has appealed the TCC decision to the Federal Court of Appeal.
Understanding the type of representations that cause property to be a tax shelter
Based on the TCC’s decision in Krumm, property may be a tax shelter even if the communications do not expressly quantify the tax benefits that a potential purchaser will receive. This broad interpretation of tax shelter may increase CRA’s use of the tax shelter rules as a reassessment tool to disallow tax benefits. The CRA has already publicly stated that it is actively reviewing certain mass-marketed plans that the CRA considers to be aggressive, such as leveraged insured annuity plans and foreign exchange loss straddling plans. Potential purchasers in any transaction should evaluate pre-transaction communications carefully to protect themselves against a possible reassessment for purchasing an unregistered tax shelter.