Tax shelters are perfectly legal mechanisms for lowering your tax burden. And while there are a limited number of legitimate shelters left, those that are available pose no problem to the Canada Revenue Agency (CRA).
Flow-through shares are tax shelters aimed at encouraging investment in Canadian resource industries and allow investors to benefit from deductions and tax credits that are ordinarily restricted to corporations.
These shares are purchased from an oil or mining company that is raising money for exploration and development projects. The shares allow exploration and development costs to be passed on to the investor by transferring the company’s Exploration Expenses and Earned Depletion Allowances.
When investors file their income tax returns, they claim those deductions or credits and cut their tax bills. Moreover, the cost base of the shares is also reduced. When the shares are sold, only 50 per cent of any capital gain is taxed.
The end result is an acceptable reduction in an investor’s tax bill.
However, the CRA is concerned about abusive tax schemes and aggressively audits tax returns with them. The agency has joined an international task force aimed at identifying and cracking down on promoters who develop and sell abusive tax shelters.
In addition, Canadian legislators are getting in on the action by passing laws that restrict limited partnership deductions to the amount of the investment. Formerly, limited partnerships were used to create investments in which the potential tax deductions exceeded the amount invested.
Legislation has also limited the donation tax credit. Donors can now take a credit only for the cost of the donation, not the fair market value listed on the donation receipt. Some scheme promoters were valuing donations far above the actual purchase price, generating huge tax credits.
As a result, there are very few tax-assisted investments still available to investors in Canada. Those that do remain have had their benefits restricted.
Basically, there are two main types of legal tax shelter investments:
Tax-deferral shelters that postpone taxes to a later time by generating a cash flow, but no taxable income. For example, a real estate investment can generate rental income that is mostly or entirely offset in the first few years by such noncash expenses as Capital Cost Allowance.
Tax-reduction shelters that flow through losses or certain types of expenses that can be applied against other income. Flow-through shares (see right-hand box above), limited partnerships, film tax credits, some donation strategies and Labour Sponsored Funds fall into this category.
Labour Sponsored Funds are a particularly attractive investment in some provinces, as they can offer both federal and provincial tax credits.
If you are considering a tax shelter, consult with your financial adviser first – promoters seldom point out all the tax implications of these investments. Among the points to consider are that tax shelters can:
Be risky. Tax credits, deductions and government incentives are offered for a reason – often to spark investment in unpopular products. A bad investment is not converted to a good investment simply by granting tax breaks.
Treat income as capital gains, so it’s up to the investor to make sure that this treatment of income is appropriate.
Create an Alternative Minimum Tax liability if the investor has significant amounts of other income but has used shelters to reduce ordinary taxes to a very low level.
Boost the investor’s Cumulative Net Investment Loss balance, which reduces the availability of the lifetime capital gains deduction.
Limit your interest deductions because interest on sheltered investments is deductible only if the tax shelter earns business or property income. Interest expense on an investment yielding only capital gains is not deductible.
Also, shelters can boost the cost of having tax returns prepared because the filing requirements become more complex. Labour Sponsored Funds are an exception, as the reporting requirements are relatively simple.
When evaluating a tax shelter, use the same common sense and guidelines as you do with any investment. A guarantee of cash flow is only as good as whoever is making the guarantee. If there aren’t enough resources to make good on the promise, the guarantee is worthless. View the shelter from a business risk and return perspective. For example, you may not want to make a tax-sheltered real estate investment in a declining market.
Final caution: Tax shelters must be registered with the CRA and have an identification number. If you buy one with no number, you cannot claim deductions. And once the CRA identifies a tax shelter for audit, every investor can expect a tax re-assessment and may face penalties.