Executive TaxBreaks, Spring 2006
06-2
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Charitable donations involving art flips – They flop!
Have you heard the one where a Canadian taxpayer buys artwork on the advice of his or her financial advisor from “ArtShop” for $500, the artwork is appraised a short time later for $1,500 by an appraiser “ArtShop” has recommended, the taxpayer then donates the artwork to a registered Canadian charity casually mentioned by “ArtShop,” and receives a charitable donation slip for $1,500?
Sounds too good to be true? It probably is. Over the past three years, Canada’s tax courts have heard cases and rendered unfavourable decisions to taxpayers involved in “art flips” or “buy-low, donate-high” situations. While proposed legislation will curb the use of such plans, these cases do illustrate pitfalls that taxpayers should avoid.
Precedents and tax concepts
Four notable cases are the 2004 tax court case of Klotz v. The Queen (Klotz) and the 2005 decisions by the Federal Court of Appeal in Nash v. The Queen (Nash), Tolley v. The Queen (Tolley) and Quinn v. The Queen (Quinn). Each case involves taxpayers who, on the advice of their respective financial advisors, purchased limited edition prints and within a short timeframe donated them to registered charities, receiving donation slips for two to three times the purchase price of the prints.
The courts were asked to consider the following tax concepts and prevailing legislation at the time the donations were made:
· What was the fair market value (FMV) of the prints when donated? This question is important because the FMV of the donated property is used to determine the donation tax credit the taxpayer is entitled to claim.
· Were the prints personal use property (PUP)? If so, under the legislation in force at that time, any increase in value between their purchase and donation dates would not be taxable as long as the FMV did not exceed $1,000 per print.
What is FMV?
FMV is a fundamental concept often referred to in Canadian tax legislation, but it is not defined in the Canadian Income Tax Act (the Act). The courts refer to various approaches or methods previously established through case law in determining FMV, with reference to the economic and legal characteristics of the transactions before them.
What is PUP?
PUP is property owned by a taxpayer that is used primarily for his or her personal use or enjoyment, or that of persons related to this individual. A taxpayer cannot report a capital loss on PUP and only reports a capital gain on the disposition of PUP if both the proceeds of disposition and adjusted cost base exceed $1,000.
The facts
While there were numerous differences between the Klotz, Nash, Tolley and Quinn cases (including the quantity of prints donated by the taxpayer, the dollars involved, the market history of the prints, and the perceived reliability of the expert witnesses used by the taxpayers), when the basic transactions were analyzed, the economics of the donation transactions were quite similar.
In each of these cases, the taxpayers were provided with donation receipts for the prints as a donation “in kind,” and the appraised FMV was two to three times the original cost. The Canada Revenue Agency (CRA), on the other hand, believed “cost” was more representative of the true FMV of the donated prints in these cases, and reassessed the taxpayers accordingly.
It should be noted that the CRA pursued the taxpayers even though the donation credits claimed were relatively small amounts. The CRA also pursued penalties and questioned whether the prints were in fact PUP.
The courts find for the CRA
Ultimately, the courts agreed with the CRA. In all four cases, the courts did determine that the art was PUP, given the legislation in place at the time of the donation, and that any gains were nonexistent as, coincidentally, the maximum value assigned to an individual print was $1,000. However, after much discussion on the appropriate methodology for determining FMV, it came down to the fact that no logical or credible explanation was provided for the increase in value of the prints, given the relatively short period of time (a few months) between the purchase and donation dates of the prints.
The Ministry of Finance reacts
Understandably, the Ministry of Finance did not like buy-low, donate-high or art flip scenarios and responded by introducing legislation to curb such transactions. First, the PUP provisions of the Act were amended to exclude property disposed of in circumstances relating to a charitable donation. Now a taxpayer must report a capital gain on the difference between the taxpayer’s cost base and the donated value. Further, detailed amendments have also been proposed, effective for gifts and political contributions made after December 20, 2002, regarding the determination of the amount of the gift or political contribution that is eligible for a donation tax credit.
What you should do
While the buy-low, donate-high or art flip plans may have been curbed by the proposed legislation, other types of tax shelters involving donations to charities continue to emerge. Before participating in such plans, some key questions you should ask include:
· Who is the promoter? What is their reputation?
· Who is the charity? Is it registered?
· If you are being asked to make a donation in kind, how is its value determined?
· Is there a third-party, independent valuator behind the valuation?
As with any tax shelter, it is important that you obtain the following additional information:
· Has an advance tax ruling been obtained from the CRA relating to the structure?
· Has a legal opinion been received in respect of the structure that fully comments on the tax implications, including how the valuation of the charitable donation is determined?
· Has a tax shelter identification number been issued?
· Has the CRA reviewed or challenged any investors of the tax shelter in previous years?
· Has a litigation contingency fund been established in the event of future CRA challenges?
While we all like to promote charity and altruism, unfortunately there are situations out there of which Canadian taxpayers should be wary: what sounds too good to be true, usually is. If in doubt about a particular plan being promoted, contact your tax advisor.
Michelle Connolly, Toronto
Death of a taxpayer - RRSP transfers to minor children
Many people are unaware of the advantageous tax treatments available when a minor child inherits funds from an RRSP.
Treatment to the annuitant
When an individual dies, he or she disposes of all property in an RRSP (matured or un-matured) at the fair market value (FMV) of the property immediately preceding the death. The full amount realized is included as a benefit in the taxpayer’s income for the year of death. Although the resulting inclusion may be substantial, some tax relief may be possible.
For example, certain payments made on behalf of the deceased taxpayer to a spouse’s or dependent’s RRSP or registered retirement income fund (RRIF), or to purchase an annuity, may entitle the deceased to a corresponding deduction on his or her final tax return to offset the income inclusion, resulting in the RRSP payout being, in effect, tax-free. However, there are conditions that must be met to obtain this deduction.
Conditions that must exist
In order for the deceased taxpayer to receive a deduction, the first condition that must exist is that the RRSP amounts must represent a “refund of premiums,” paid out in a lump sum. A refund of premiums is an amount paid out of an RRSP (other than a tax-paid amount in respect of the plan) as a consequence of the death of the annuitant under the plan, which is paid to:
· a spouse or common-law partner of the annuitant, where the annuitant died before the plan matured, or
· a child or grandchild of the annuitant who was, immediately before the death, financially dependent on the annuitant for support, and the amount was paid under the RRSP (matured or un-matured) after the death of the annuitant.
Determining whether a child is financially dependent on an individual can be subjective. As a general rule it is assumed that, unless the contrary is established, the child was financially dependent on the deceased taxpayer if:
· where the child is not mentally or physically infirm, their income for the prior year did not exceed the basic personal exemption claimed ($8,648 for 2005), or
· where the child is mentally or physically infirm, their income for the prior year did not exceed the basic personal exemption plus the annually indexed lump-sum payment (a total of $15,140 for 2005).
It is important to note that the onus is on the child, or his or her legal guardian, to prove financial dependence on the annuitant immediately prior to the death. If this is successfully demonstrated, then the amount paid to the child will be deducted from the benefit inclusion in the income of the deceased.
Treatment to the minor child or grandchild
Amounts paid to a financially dependent child will be included in his or her income for the year they were received, and are thus subject to tax. However, just as the deceased taxpayer received tax relief, as described above, the financially dependent minor child may be entitled to a corresponding deduction. It all depends on what is done with the RRSP payout.
To qualify for the deduction, a minor child that is not mentally or physically infirm must purchase a specific type of annuity with the funds. The annuity purchased must meet the following criteria:
· the child or grandchild is the annuitant,
· the annuity must come to term by the end of year in which the child turns 18, and
· the annuity must be acquired in the year the funds were received or within 60 days after the end of that year.
In the case of a child that is dependent by reason of mental or physical infirmity, the funds can be used to purchase a life annuity, a term-to-age-90 annuity, a RRIF, or an RRSP.
The effect of this deduction is to enable a tax-free transfer of the refund of premiums to a financially dependent minor child.
Physical flow of funds
The amount of the refund of premiums from the deceased taxpayer’s RRSP can be paid either directly under the RRSP (i.e., rolled over to a new instrument) or indirectly through a trust or the estate of the deceased.
When a minor child is to inherit funds from a taxpayer, we must consider how the monies will flow from the deceased’s RRSP to the child. In general, minor children cannot enter into legally binding agreements or legal transactions, such as acquiring an annuity, in order to receive the RRSP funds. Therefore, the child receiving the refund of premiums will need a legal guardian or representative to carry out the resulting legal requirements.
Mike Bird, Calgary
Angela Smith, Calgary
Breaking News
Reporting requirements for independent contractors
Recently, the Canada Revenue Agency (CRA) has expressed concerns that independent contractors are under-reporting their income. Technically, Regulation 200(1) of the Canadian Income Tax Act (the Act) requires that amounts paid to independent contractors for “fees, commissions, or other amounts” be reported on a T4A slip. However, the CRA has not been actively enforcing this rule because of the vague wording used in the legislation.
This practice will likely change as the CRA is currently reviewing the issue. The CRA may either amend the Act to provide greater clarity or change its administrative policy and start strictly enforcing the requirement to issue T4A slips based on the current provisions of the Act. It is also likely that the T4A slip will be amended for the 2006 taxation year to include a specific box for consulting fees. Payments to an independent contractor totaling less than $500 for the year will likely continue to be exempt from the requirement. There would be no change to the current exemption from withholding on payments to independent contractors.
Deloitte will be monitoring this situation. Look for updates in future editions of Executive TaxBreaks.
Andrea Heimrich, Toronto
Tax avoidance schemes purporting to be retirement compensation arrangements
The Canada Revenue Agency (CRA) recently expressed the concern that certain tax plans are being inappropriately promoted as retirement compensation arrangements (RCAs).
An RCA is a retirement savings vehicle used to supplement the pension benefits that can be provided to an employee or owner/manager by a registered pension plan. Contributions are made by the employer to a trust established for the benefit of the employee or owner/manager. Employer contributions are deductible at the time the contribution is made. The employee or owner/manager is not taxed on either the value of the contributions or investment earnings accumulating in the trust. Investment earnings and contributions are, however, subject to a 50% tax that is refunded when payments are made to the employee or owner/manager when he or she retires or terminates employment. The amount received by the former employee or owner/manager is taxable as “other income.”
The CRA provided several examples of plans that, in its view, are being inappropriately promoted as RCAs:
· Corporations making excessive contributions for the benefit of owner/managers who receive the amounts after becoming a non-resident of Canada
· Corporations using RCAs to streamline long-term corporate profits
· Corporations claiming deductions for contributions that are part of a series of contributions and loan backs
The CRA has indicated that such plans will be targeted for audit. In particular, the CRA will deny the corporate deduction and/or tax the employee or owner/manager, on a current basis, on all or part of the value of the contributions and earnings accumulating in the RCA.
In light of the CRA’s comments, plans promoting the use of RCAs should be carefully scrutinized. If you have questions about a particular plan, contact your local Deloitte advisor.
Marsha Reid, Toronto
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Source: Deloitte & Touche LLP - Canada (English)
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