More than 2,500 participants in “buy low, donate high” art-flip tax shelters may be reassessed for thousands of dollars in unpaid taxes — unless tax lawyers fighting four test cases can persuade the Supreme Court of Canada to hear their appeals.

Advisors who referred clients to these tax shelter promoters should also hope the lawyers succeed. If not, advisors could be dealing with angry phone calls from departing clients.

In late November, the Federal Court of Appeal overturned the Tax Court of Canada decision in a trio of cases, known collectively as Canada v. Nash. The cases — brought by Cademon Nash, Barbara Quinn and Susan Tolley on behalf of 1,850 taxpayers involved in an art-flip donation program run by Toronto-based CVI Art Management Inc. — came before the Tax Court in 2004.

The FCA had already rejected in May the appeal of Toronto investment executive Frank Klotz, who had claimed a tax credit of $258,400 through another Toronto-based shelter, Art for Education, but lost in Tax Court after the credit was denied by the Canada Revenue Agency. Now all four are seeking leave to appeal the FCA’s decisions to the SCC.

The key issue in the art-flip cases is determining the “fair market value” (FMV) of the art, because that value decides the amount of the tax credit a taxpayer can claim for a charitable donation of art.

The SCC may not think the FMV of art — particularly in the context of art-flip tax shelters — is important enough to bother hearing the four appeals. The lawyers will bring their motions for leave to appeal before the end of January.

Hefty appraised values

In a typical art flip, the tax shelter promoter buys works of art in bulk at very low prices, perhaps $50 each, and sells them to tax shelter participants for about $300 each. Then the art is appraised at approximately $1,000 for each piece and donated in bulk to a public institution — often a U.S. university — that issues a tax receipt for the aggregate appraised value.

One source of clients for these shelters has been financial advisors, to whom the promoters pay referral commissions. The message advisors should take from the Nash decision, says Jamie Golombek, vice president of taxation and estate planning at AIM Funds Management Inc. in Toronto, is to be careful about getting involved in these tax shelters. “If a client is reassessed, it will make him or her question every investment ever made with you,” he says.

“Clients and advisors should do the math,” adds Heather Evans, partner and tax lawyer in the Toronto office of Deloitte & Touche LLP. “If you’re making a gift, why would you be that much better off? Giving involves some degree of sacrifice.”

Golombek agrees: “It has always boggled my mind how a person could pay one price for art and get a tax receipt for many times the price. It’s too good to be true.”

Determination of FMV is generally seen to be a “finding of fact,” and appeal courts do not overturn trial courts’ findings of fact unless it can be shown the courts made “a palpable and overriding error.” In its Nash decision, the FCA maintains the Tax Court made two such errors.

First, the Tax Court accepted the appraiser’s aggregate valuations, based on the value each print would get in the retail market, instead of looking at the market in which the prints were actually sold to each taxpayer (the market created by the promoter).

Second, the Tax Court judge agreed the FMV of the prints was about three times the amount the taxpayers paid for it “with no credible evidence for the apparent threefold increase.”

The FCA seems to be applying the present state of the law, as opposed to the law that existed when the taxpayers got involved in the art flips. In December 2003, the Finance Department unveiled Income Tax Act amendments to shut down all “buy low, donate high” tax shelters, including art flips. The amendments still haven’t been passed, but because of the retroactive nature of tax amendments, they are considered law by the tax community.

The CRA is going after almost 10,000 art-flip shelter participants whose investments predate the 2003 amendments. Taxpayers have two arguments against CRA attacks: one, if the appraised value of the art is fair, they should be able to claim a tax credit for it; two, even if the flips are now viewed as repugnant by Ottawa, they were permissible under the law predating the amendments. So far, the FCA doesn’t agree. And it remains to be seen what the SCC will do.

@page_break@First test case

The first test case on the FCA’s docket was Klotz v. Canada. In May 2005, the FCA upheld the Tax Court’s decision denying Klotz’s tax credit claim. One of 660 participants in the Art for Education shelter, he donated 250 prints to a U.S. university in 1999.

“It is one thing to pick up a long-lost masterpiece at a garage sale for $10, give it to an art gallery and receive a receipt for its true value,” wrote Judge Donald Bowman in his March 2004 Tax Court decision. “It’s another for [the promoter] to buy thousands of prints for $50, create a market at $300 and hold out the prospect of a tax write-off on the basis of a $1,000 valuation.”

Bowman decided the best evidence of what the art is worth is what the tax shelter participant paid for it ($300 each, in Klotz’s case). The FCA agreed.

Klotz is seeking leave to appeal from the SCC, says his lawyer, Doug Mathew, partner in the Vancouver office of Thorsteinssons LLP. Mathew says Bowman made an error in law by failing to look at the market that would yield the highest value.

The Nash plaintiffs won in Tax Court, in which Judge Ronald Bell accepted the appraiser’s opinion on FMV. The appraiser used a market-comparison approach — contacting dealers, galleries, publishers, artists and Web sites — to value each piece before coming up with the FMV for each of the three taxpayers.

“Our clients will seek leave to appeal the FCA’s decision to the SCC on the basis that the trial judge did not make an error and the Appeal Court should not have substituted its view of the evidence for that of the trial judge,” says Cliff Rand, the Toronto-based partner with Stikeman Elliott LLP, who represents Nash, Quinn and Tolley. IE