As soon as I qualified for my CA degree in 1981, I transferred out of the audit group at Ernst & Whinney (one of the Big Eight accounting firms at that time which through subsequent mergers is KPMG today) into their tax practice. I learned the fundamentals of the tax system over the next 5 years and when I joined Mintz & Partners in the spring of 1986 I was finally ready to add tax planning to my suite of tax practice offerings. The timing of my move to Mintz was impeccable, as the period from the mid-1980’s to the end of the century was considered by many tax professionals as the “wild, wild west”. There were many tax planning opportunities, often referred to as loopholes, that the tax legislation allowed. From an income tax perspective, a loophole is generally considered as an ambiguity or inadequacy in the tax law and many smart tax professionals advised their clients of loopholes that allowed them to avoid tax. It is very important to understand the distinction between tax avoidance and tax evasion. In simple terms, evasion is illegal, while avoidance is not. Tax avoidance is an attempt to legally reduce or prevent a tax liability that would otherwise be incurred, by taking advantage of some provision or lack of provision in the law.
I find that paying taxes is kind of like buying gas for your car. No matter how hard you look for the best deal, you always have a nagging feeling that someone else is paying less than you.
During the 80’s and 90’s, many taxpayers would proudly share their tax strategies on the cocktail party circuit. What if someone came up to you and said, “Guess what? I finally got my own tax shelter. I made a donation of $7,500 to some charity and got a tax receipt for $30,000. Amazing huh??!!” Your immediate reaction would probably be, “who left me off the tax avoidance party invite list?” While most Canadians regard avoiding taxes as something between a duty and an obsession, it is clear that most of us do not want to be paying any more than we absolutely have to.
There were two major strategies that were utilized to legally sidestep taxes. The first was to fund certain types of investments that the government wanted to encourage. The government deliberately equipped these “tax-assisted investments” with generous tax breaks precisely because it wanted to help them attract investors. The second way you could sock it to the taxman was to exploit loopholes in the tax laws in order to claim oversized tax deductions. These types of manoeuvres were (and are) termed tax shelters and were typically the work of sharp-eyed lawyers and accountants who spotted unexpected ways to legally beat the system set up by the legislators and bureaucrats. While the two types of tax avoidance are quite different, they both involve risk. Consider, for instance, the sad history of Multiple Unit Residential Buildings (MURBs), or what most of us would call apartment buildings. Back in the 1970s, Ottawa decided to encourage investment in this sector by allowing investors in new apartment buildings to claim their annual capital cost allowance (i.e. depreciation) against other income. Promoters quickly took advantage of that offer and constructed leveraged deals that allowed MURB investors to put down as little as 10% of their total investment while giving them an immediate tax break almost as big as their initial cash outlay. All of which was fine until the real estate market crashed in the late 1980s when vacancy rates soared and a lot of these taxpayers found they couldn’t sell their tax-assisted MURBs for love or money. The prospects of immediate tax savings blinded people to the economic reality of the underlying investment. The investors weren’t thinking about the long-term implications.
That lesson went unheeded in the 1990s when investors flocked to Labour-Sponsored Investment Funds (LSIFs). These were essentially mutual funds that invested in small start-up firms. Investing in such businesses had always been notoriously risky, so the federal and provincial governments decided to offer tax credits worth 30% or more of the initial investment to encourage as many investors as possible to take the plunge. Unfortunately, most labour funds turned out to be dogs. Adding misery to discontent, those who invested in labour funds were required to hold their poorly performing investments for a minimum of eight years or pay back all the tax credits they had already claimed. The dismal track records of MURBs and LSIFs demonstrates that no tax advantage can compensate for a fundamentally lousy investment.
That brings us to tax shelters. While the government approved of tax-assisted investing, it clearly was no fan of tax shelters. These shelters were the work of tax professionals who loved to dream up clever tax reduction opportunities and in doing so, they often incurred the wrath of the CRA, which, of course, wants to collect as much tax as it can and views fancy tax avoidance schemes with deep suspicion. As with MURBs and LSIFs, the smart tax professional continued to take tax provisions that were enacted to assist various industries, like Canadian movie production and scientific research, and package them to investors looking for a break on their taxes. Another example was the “buy low, donate high” programs that bought art (as well as other capital properties) at low prices and used questionable valuation techniques to donate it to charity in return for a tax receipt based upon values as much as three times the original purchase price. The advantage of tax shelters like these is that they couldn’t wipe out your capital the way a tax-assisted investment could. On the other hand, you ran the risk that the CRA would decide your shelter ran afoul of the law and challenge it in tax court. In fact, most of the above tax shelters were shut down when the government took action to either clarify or change its laws. However, before that happened, many tax shelters were challenged, and most successfully by the CRA in court, such that the participants lost their deduction or credit for that year. They may have also faced being assessed penalties depending on their involvement in choosing the shelter.
In the last few years of the 1980’s the government introduced the General Anti-Avoidance Rule (GAAR). The GAAR, in essence, legislated that where a transaction or a series of transactions achieved a reduction, avoidance or deferral of tax, and those transactions or series of transactions were not conducted for any primary purpose other than to obtain a tax benefit, the tax consequences may be invalidated. The introduction of the GAAR represented an effort on behalf of the government to stop what it perceived was improper and costly tax avoidance. Simply put, the government was frustrated with its inability to close loopholes by other and less general means. They were of the view that taxpayers, ably assisted by their tax advisers, were able to open holes in a revenue dike faster than they could close them with specific amendments. The government found that it took considerable time to learn of the loopholes and to devise specific amendments to close them. They also found that the correcting amendments were not always adequate to their task. Furthermore, the government tried to somewhat accelerate the loophole-closing process by making tax amendments by press releases, effective from the date of the announcement. Some would say that many of the loopholes were self-inflicted wounds caused by the government’s tendency to introduce new and overly complex legislation without thinking them through and as a result of the CRA’s inadequate efforts to police and assess on the basis of the law as it existed.
The GAAR was introduced with the intention of giving the CRA increased abilities to target and challenge possible cases of tax avoidance and/or abuses of the tax system. Until the GAAR was introduced, no previous general anti-avoidance measures had been in place. Despite a CRA circular that outlined what the GAAR covered, from the date of its introduction in 1988 up until 1995, no judicial pronouncements were made. As such, tax loopholes continued to flourish for much of the 1990’s. However, by the start of this century and over the past 19 years, the government has made many legislative changes to close perceived loopholes. These include severely limiting the benefit of legally utilizing offshore structures, introducing complicated rules that limit family income splitting (commonly referred to as the TOSI rules), and reducing access to the low corporate tax rate on active income where the company earns too much passive income. These types of legislative changes, combined with the spectre of GAAR and the taxpayers’ weariness of fighting their use of loopholes through the courts, led to a change in most taxpayers’ hunger for tax avoidance. Don’t get me wrong, everyone still strived to pay the minimum amount of tax; they simply were doing so without the benefit of the loopholes that had been plugged.
Where have all the loopholes gone, long time passing? Where have all the loopholes gone, long time ago?