Tax Angles: Deduction restrictions not applicable

A basic ingredient of any tax shelter arrangement is the acceleration of the realization of tax deductions and credits by the introduction of taxable investors into those situations where such deductions and credits would not otherwise be utilized in a timely manner. This permits the economic analysis to be done on an after-tax rather than a before-tax basis. A company not currently taxable considers the potential return on a $1,000 outlay. If an investor, fully taxable at 50%, invests $1,000 in a tax shelter that provides a $1,000 deduction from income, his after tax cost will be $500. His investment decision is made on the basis of the anticipated after-tax return on this $500.

The introduction of leverage into the investment can have a dramatic effect on returns. If an investor puts up only $500 of his own money in the first place, with the balance of the investment financed with debt, and the investment still provides a $1,000 deduction from income, then the investor has no out of pocket after-tax investment. If the investor is required to put up less than $500, the tax recovery will exceed the investment, and this net cash inflow becomes part of the economic benefit. Who Must Pay Off the Debt?

If the investor is personally liable for the debt, he has only obtained a timing advantage. If the investment turns sour, he will have lost his after tax cost in the investment. Many tax shelters are structured to protect an investor from this unfortunate event. One example is the use of “non-recourse” debt, that is secured only by the investment itself. Another common technique is the use of the limited partnership vehicle, where the investor is a limited partner and not personally liable for the debt leverage within the partnership. Government Reaction

Over a number of years the government has gradually moved to curb the use of tax shelters that either provided “undue” tax advantages or became so widely used as to have a significant impact on government revenues. One approach, to date only applied to shelters involving tax depreciation, has been to limit the tax savings in the early years of an investment by not permitting tax depreciation claims in excess of the income from the related property. This restriction was first legislated in 1972 with respect to rental real estate investments, and was extended to leasing properties (such as aircraft, ships, railway cars) acquired after May 25, 1976 and to certain investments in hotels, yachts and nursing homes acquired after May 22, 1985. A second approach was to attempt to curb the use of leverage especially in limited partnerships through a form of suasion — or perhaps intimidation. Revenue Canada stated publicly that in its view a limited partner’s share of partnership losses, deductions and credits was limited to the amount of his investment in the partnership and that allocations in excess of this limit would be denied on re-assessment.

Some ingenious promoters found ways to tip toe around the administrative guidelines in structuring leveraged limited partnerships and obtained advance income tax rulings to ensure safe passage through the tax net. Other more aggressive promoters and investors simply proceeded with leveraged partnerships bolstered with legal opinions to the effect that a Reve nue Canada attack would not be successful. Faced with a rising tide of leveraged deals and with trends in court decisions that indicated Revenue Canada might indeed fail in its attacks, on October 24, 1984 Revenue Canada and the Department of Finance jointly announced a moratorium on providing advance income tax rulings on limited partnership arrangements. This was intended to give the government some breathing room to consider the whole issue of leveraged tax shelter investments. At the same time, it denied taxpayers their right to obtain clear interpretations from the tax authorities under the tax law as it was then written.

In the federal budget of February 26, 1986, the Minister of Finance introduced measures that will provide legislated limits to the allocation of investment tax credits and business losses to partners of limited partnerships and certain general partnerships where personal liability is effectively limited. The details of the legislation are contained in the comprehensive Ways and Means Motion tabled on June 11, 1986. Basically, it is proposed that investment tax credits and losses of a partnership allocated to a limited partner will be deductible by him only to the extent of his “at-risk” amount. A bright note for resourceful investors is that this legislated deduction restriction is not to apply to Canadian exploration expense or Canadian development expense allocated to a partner.

In our next article we will examine new “at-risk” rules in more detail. Mr Playfair and Mr Dent are tax partners at Clarkson Gordon, Toronto.