If tax shelters sound too good to be true, then they probably are. That appears to be the Canada Revenue Agency’s view of tax-sheltered gifting arrangements, which have been subjected increased scrutiny by the CRA.

Last August, the CRA, which has been urging taxpayers to avoid these arrangements for several years now, advised taxpayers that it plans to audit all such arrangements, leaving donors at risk of reassessments of their tax returns.

According to the CRA’s Aug. 13 Taxpayer Alert, the agency claims that “every audit completed to date has resulted in a reassessment of tax, plus interest.” In some cases, the CRA has denied the gift completely and has considered penalties in which “an investor was audited and reassessed for previously participating in a gifting arrangement.”

So far, the CRA has reassessed more than 26,000 taxpayers who have participated in gifting arrangements and denied about $1.4 billion in donations claimed. The CRA is about to complete another 20,000 taxpayer audits in which there are claims of more than $550 million in donations; it will commence an audit of another 50,000 taxpayers.

The Income Tax Act defines a tax shelter as either a gifting arrangement or the acquisition of property in which the purchaser or donor is informed that the tax benefits and deductions arising from their participation will equal or exceed the net cost of entering into the transaction; or a gifting arrangement in which the donor incurs a limited-recourse debt related to the gift. Generally, a limited-recourse debt is one in which the borrower is not at risk for the repayment of the debt.

The structures of gifting arrangements vary and can be classified under two broad categories: “debt and donate” and “donate and become a beneficiary.” Each arrangement typically has a common element — a captive charity to which participants make donations, says Michael Fromstein, a tax consultant with North York, Ont.-based Integrated Professional Specialist Services.

In “debt and donate” arrangements, taxpayers “borrow” funds to supplement a small cash outlay — usually less than 20% of the total donation — and then donate the cash and borrowed funds to a charitable foundation, which issues a tax receipt equivalent to the cash and the loan. The foundation, in turn, donates the borrowed funds to one or more registered charities and uses the cash portion of the donation as a security deposit on the loan.

In some arrangements, the cash is used as an “investment fund” that will supposedly grow to repay the original debt, assuming an unusually high compounded annual rate of return of about 30%, potentially leaving the donor with no risk of repaying the loan.

In other arrangements, the charity uses the donation to purchase an annuity that returns sufficient funds to cover the loan over a defined period of time.

In some “debt and donate” arrangements, the borrower can repay the loan in kind. The cash is used to acquire property — such as pharmaceuticals or software — which is then donated to a charity. Typically, the in-kind property is significantly overvalued by the promoter, resulting in an inflated tax receipt.

In “donate and become a beneficiary” arrangements, the donor makes a small cash donation to a charity and becomes a beneficiary of a trust that is associated with the charity. The trust acquires property — such as software or pharmaceuticals — and gives the donors units that represent the pro-rated value of this property. These units of the trust are then donated to a designated charity. The charity issues a receipt for the inflated value of the property associated with the units. The donor also receives a receipt from the initial donation of cash.

Typically, the tax receipts issued by both “debt and donate” and “donate and become a beneficiary” arrangements amount to three to four times the initial cash payment of the donor, running afoul of legislation proposed by the CRA in 2003, which seeks to reduce the donation to no more than the actual cash outlay by the donor. The CRA has also indicated that its audits have concluded that in many cases, no gifts have effectively been made by donors — resulting in the donation being reduced to zero.

Yet the structures of gifting arrangements have been subject to ongoing changes aimed at getting around the CRA rules. Gena Katz, executive director of the tax practice at Ernst & Young LLP in Toronto, says that the underlying fundamentals of these new structures remain the same, but with modifications to the gifting process.

@page_break@However, she cautions, this does not mean that they will pass the CRA’s “smell test.” The CRA is aware, she says, that “new schemes are being marketed that claim to be different from those for which the CRA has previously issued warnings.” She has cautioned taxpayers to “avoid all schemes that promise donation receipts for three to four times the cash payment.”

So, why do tax-shelter arrangements continue to survive —in spite of repeated warnings from the CRA?

The simple answer is that taxpayers “like to have the impression that they can beat the system,” says David Louis, a tax partner with Toronto-based law firm Minden Gross LLP. He adds that some promoters “got caught in the business” even as the CRA progressively introduced stricter rules.

At the same time, promoters have leveraged tax opinions provided by law firms on their various initiatives, giving donors a false sense of security that their arrangements are legitimate. Katz advises that law firms generally provide opinions on a certain set of features that “do not necessarily hold water with the CRA.”

Louis adds that these opinions are often “smoke and mirrors,” dealing with a limited number of issues but ignoring others.

“It’s a lot of waffling,” Katz says.

The fact that all tax shelters must have an identification number issued by the CRA has also provided a perceived sense of legitimacy to such arrangements. However, this is a CRA tracking requirement that is used to identify the shelters and their donors, and does not mean that the CRA has approved them.

Implicit in the CRA’s decision to audit all tax-sheltered gifting arrangements is the fact that the CRA has not necessarily provided an official tax ruling on any existing arrangements.

Regardless of how promoters structure their gifting arrangements, Fromstein says, based on assessment letters from the CRA, questions arise over myriad issues, among them: the true, independent valuation of property that is part of some arrangements; whether donors actually acquired property or were active in selecting it; that the donor actually incurred any real debt when making a donation; that there was any intention to repay the debt; and that the charity had unfettered use of all monies for which receipts were issued.

Fromstein cautions that the courts have held that even valid contracts are not enough if the parties did not intend to live up to the spirit of the agreement. He suggests that a pre-arranged promoted agreement to swap debt for allegedly overvalued product might not be considered a legitimate transaction in court.

Evidently, tax-sheltered gifting arrangements are only for the brave who are willing to take on the CRA in court, making use of substantial legal defence funds that promoters claim to have set aside. So far, the CRA seems to be winning, and the only losers are taxpayers who end up with huge tax bills, penalties and interest charges. IE