Tax shelter – Page 2 – Doug Carroll

Government scrutiny of 10-8 insurance programs

At issue

The 2013 Federal Budget took aim at a number of items of concern to the government in terms of unintended tax benefits, including 10/8 life insurance programs.

A 10/8 arrangement involves investing in a life insurance policy with a view to borrowing against that investment for the purpose of creating an annual interest-expense tax deduction for a long period of time (i.e., until the death of an individual whose life is insured under the policy).

Since 2008, the Canada Revenue Agency has publicly expressed its interest in examining and understanding these arrangements. In a sense, the proposed Budget measure may be seen as the government’s legislative response to the lack of success of the CRA on this compliance front.

CRA roundtable, Canadian Tax Foundation Conference – December 2008

During the CRA Roundtable portion of the annual CTF conference, CRA officials commented that the GAAR (General Anti-Avoidance Rule) committee had recently reviewed a 10/8 plan submitted for review. The details of the review were not disclosed, other than to remark that there was a question about interest deductibility.

Initially the industry expectation was that CRA may begin pursuing and challenging such plans under the GAAR. Instead, efforts seem to have been directed toward gathering more information by expanding the scope of insurance company audits.

MNR v RBC Life, 2013 FCA 50

In a series of ex parte motions (ie., moving party alone before the court) in 2009 and 2010, the CRA obtained judicial authorization to require four life insurers to disclose information and documents relating to their respective 10/8 plan holders. Each motion rested on the premise that the “information was required in order to verify that these persons are in compliance with the [Income Tax] Act.”

The desired personal information included names, social insurance numbers, business numbers and trust numbers. The plan and activity requests covered policy numbers, loan amounts, cash surrender values, and interest particulars.

The insurers successfully challenged the orders at the Federal Court. The presiding judge had in fact sat on two of the original ex parte motions. The reasons cast the CRA in an unfavourable light, documenting in detail a failure to make “full and frank disclosure” during the ex parte motions. In particular, the judge was critical of the CRA’s intention to “send a message to the industry” by way of an “audit blitz” to “chill” 10-8 plan business.

CRA appeal to the Federal Court of Appeal, but was denied.

Federal Budget – March 21, 2013

The Budget document referred to the government’s efforts to challenge 10/8 arrangements under existing income tax provisions. However, due to time-consumption and costs, the determination was made to introduce legislative measures to prevent 10/8 arrangements from being used in the future.

As proposed, for taxation years ending on or after March 21, 2013, where one of these policies is pledged as security for borrowing, the following income tax benefits will be denied:

Deductibility of interest;
Deductibility of insurance premiums; and
Increase in the capital dividend account otherwise occurring on the payment of a death benefit to a private corporation.

Generally these changes are proposed to apply to payments occurring and periods commencing after 2013.

Practice points

Individuals contemplating or already holding an insurance policy that has or may have a borrowing component should verify with their insurance advisor whether these proposals may apply to them.
Existing 10/8 holders should consult with their insurance advisor and a tax advisor to consider options.
Generally, a withdrawal from an insurance policy has tax consequences. The Budget proposes to provide some tax relief for a 10/8 holder who makes a withdrawal in order to repay associated borrowed funds. As proposed, this relief will only be available for withdrawals before January 1, 2014.

Ponzi distribution taxable after all – Appeal court reverses trial decision

Several recent high-profile Ponzi schemes have stolen fortunes and unfairly tainted the financial advisory profession. In truth, it’s inappropriate to call the perpetrators of these schemes advisors, since they’re pursuing their own selfish interests, not those of their investors, whose trust they’ve betrayed.

To add insult to injury for victims, losses incurred in a Ponzi scheme are rarely deductible when calculating income tax.

In a surprising decision in 2011, a trial judge determined one innocent Ponzi scheme investor who had a net-positive result would not be taxed on the gain. The finding was overturned by the Federal Court of Appeal (FCA) last September, but the fight may not be over yet.

Anatomy of a fraud

In 1997, a mutual friend introduced DMJ to Andrew Lech, who said he was the financial manager for a family trust. Lech offered to combine DMJ’s money with the trust’s funds, purportedly to invest in options contracts on an ongoing basis.

On numerous occasions between 1997 and 2003, DMJ gave Lech a cheque in exchange for eight-to-10 postdated cheques of his own, with the last one representing DMJ’s gains. To sweeten the deal, Lech gave written assurance that any associated taxes would have been paid by the trust, so DMJ didn’t have to report any income on her tax return.

The scheme came to a screeching halt in April 2003 when the police froze Lech’s bank accounts. Forensic auditors determined that from 2001 to 2003 alone, almost $50 million had passed through Lech’s hands.

A civil class-action suit, a criminal case, and regulatory action by the Ontario Securities Commission followed. In 2007, Lech was convicted of fraud and sentenced to six years in prison — on top of the three he spent in pre-trial custody.

The Queen v. DMJ

The CRA audited 132 of the participants in the scheme and concluded 32 — including DMJ — profited from their involvement. To be clear, it was not alleged DMJ was involved in the fraud; the authorities said she profited innocently.

In 2007 DMJ was reassessed by the CRA for income of $614,000 in 2002 and $702,000 in 2003.

DMJ appealed the reassessments, but conceded during the legal proceedings that these sums accurately reflected the gains she received from Lech. However she contended that no income was actually generated over the course of the transactions, and therefore there was no legal basis for the CRA to assess her for tax on those receipts.

At trial in November 2011, the judge found the gains were not sufficiently connected to DMJ’s original capital to treat them as coming from a taxable income source. In the judge’s words, “nothing was actually earned with that capital. … The Net Receipts were nothing more than the shuffle of money among innocent participants.”

Effect of a scheme on taxation

As noted, the Crown was successful in its appeal to the FCA in September 2012. The appeal judgment emphasizes that “whether a Ponzi scheme is a source of income to a particular person, whether innocent or not, is a question that must be answered on the basis of the facts relating to that person.”

According to the FCA, when the relationship between two parties is based on fraud, there can be no source of income. In this case, however, DMJ received a contracted return from Lech in a business relationship. The manner in which Lech generated the funds for those returns was irrelevant, even if it was through an unlawful Ponzi scheme.

DMJ has applied for leave to appeal to the Supreme Court of Canada. It is docket 35090 on the SCC website.

Of horse breeding, tax losses and RRSPs

“The very term “Arabian horses” takes me back to the early 1960s watching in awe as Lawrence gallantly galloped across the Arabian sands on a sinewy strong stallion. The power, the grace, the beauty – it was unforgettable.”

So begins the judgment in the case of Teelucksingh and the Queen. It seems almost a shame to bring this eloquent prose back to the ground by bringing up taxes, but that is what it was all about after all.

It’s a horse race that has spanned 18 years since first assessment – and 11 days in court – and at the pole the taxpayer appears to have nosed out the Queen.

The plan is conceived

The genesis of the tax plan was the financing of a herd of Straight Egyptian Arabian horses. In order to build a sufficiently sized herd to be a viable business venture, Montebello Farms needed to gather cash. It struck upon the idea of pooling disparate investor funds through the use of a limited partnership structure.

Using example numbers detailed in the judgment, the key events in the arrangement were as follows:

Under an Offering Memorandum, an investor borrowed $18,000 from Montebello, to acquire a limited partnership interest and common shares in a corporation
At closing, current and prepaid expenses (including horse inventory) led to a farming loss distributed at $9,520 per unit, some useable that year and the rest carried forward
Following closing, the partnership transferred the assets to the corporation in exchange for preferred shares, which shares were distributed to the limited partners about 45 days later upon planned dissolution of the partnership
The preferred shares were structured to qualify for deposit to the investor’s RRSP, which at purported fair market value allowed for a swap-out of $18,236 in cash, the bulk of which was then used to retire the Montebello loan
Dividend payments of $45,000 were made in each of the two following years, after which the corporation was dissolved

A bump in the road

Mr. Teelucksingh was one of hundreds of Montebello investors reassessed by Canada Revenue Agency (CRA). He participated in two Offerings, commencing in 1993 and 1995 respectively. In 2001, he was reassessed, with the restricted farm losses being denied and the RRSP transactions being treated as taxable withdrawals.

On appeal at the Tax Court of Canada, the judge summarizes the horse operations, but otherwise makes it clear that the case “is about the tax consequences of the investing arrangement more than about the intricacies and complexities of the horse business.”

The result would turn on the legitimacy of the partnerships, the valuation of the horses, and the reasonableness of two years’ prepayment of expenses.

Down to the wire

Interestingly, the judge did not find fault with the bona fides of the partnership nor with the complex series of transactions, expressing his only reservation to be “the inflated value of the horses.” Caught between optimistic and pessimistic expert testimony on either side of the dispute, the judge arrives at a compromise valuation for the horses at something less than half of the original values.

As to the prepayment, he stated, “While I have some concern as to the commercial reasonableness of such a prepayment provision, I have nothing concrete upon which to substitute my judgment for the partnerships’ judgment.”

Thus, almost two decades after supporting the herd, Mr. Teelucksingh will enjoy both the farming losses and RRSP gains, though not as lucratively as initially projected.