Published: April 13, 2020
Last Updated: November 11, 2021
The last quarter of the year is when many taxpayers traditionally do much of their income tax planning. For taxpayers who are well into the top marginal tax bracket, typically those with income in excess of $100,000, tax shelters are often a significant method of deferring or saving on potential tax liabilities. For this reason, many tax shelter products are marketed in the last quarter of the year. The other busy period for the sale of tax shelters is in the beginning of the year. Federal budgets are usually released in February and from time to time take aim at specific tax shelters. Therefore taxpayers who require shelter will often purchase it before a Federal budget to ensure that the have the benefit of any grandfathering.
Tax shelters typically provide either absolute income tax savings by way of deductions in the year of purchase or deferrals by way of deductions in the year of purchase to be followed by income to be recognized soon after.
Mutual fund commissions tax shelters and certain film tax shelters are typical examples of deferral type shelters. They are structured so as to reduce the business risk as much as possible and to produce as foreseeable a stream of revenues as is possible. This revenue stream typically starts one or two years after the year in which the tax shelter was purchased. When this revenue stream is paid to the taxpayer, it is included in income. The taxpayer will typically be left with a positive return on his investment after tax. Accordingly these investments amount to a deferral of income from one year to several others. Of course there is always some element of business risk even in these deferral type of shelters and accordingly the ultimate financial position of the taxpayer will depend to some extent on whether the investment is successful or not.
A tax deferral type of tax shelter is extremely attractive to taxpayers who have a one time large income problem and who wish to defer part of this to future years when the income will be lower.
The other form of tax shelter typically involves significant business risk and therefore an absolute tax deduction with no predictable income inclusion. Tax shelters of this type include real estate or software, the latter having been popular in the last 2 years.
In evaluating tax shelters, particularly those involving a business risk, it is important to evaluate the tax shelter in the same way as a non-tax shelter investment. That is to say legal and accounting advisers should be consulted and the investment should be examined from a business risk and return point of view. For example, with a real estate investment, the real estate market in the target area should be examined. It may not make a lot of sense to acquire real estate, even if tax sheltered, in a market which is declining.
It is also very important to fully understand the nature and structure of the investment. Often these investments will have future cash flow requirements. Although these future payments may give rise to income tax deductions, it is essential that an investor have the ability to meet the required payments on an ongoing basis. Consultation with a professional who has experience in evaluating this type of investment is essential to ensure that an investor knows exactly what he is purchasing.
It is also important to remember that tax shelters can become a target of Revenue Canada scrutiny or attack. In December 1994, Revenue Canada issued a press release which adversely affected a number of tax shelters then being marketed by introducing new rules which had to be complied with. That was not the only case of Revenue Canada attempting to “close down” tax shelters through announcing new rules in a press release. Such press releases are indicative of Revenue Canada’s attitude to the type of tax shelter which was targeted and indicate that an investor may very well have a fight on his hands down the road. A potential future fight should not in and of itself be determinative of whether or not to make a tax shelter investment but any potential investor should be certain to factor it into the equation.
"This article provides information of a general nature only. It is only current at the posting date. It is not updated and it may no longer be current. It does not provide legal advice nor can it or should it be relied upon. All tax situations are specific to their facts and will differ from the situations in the articles. If you have specific legal questions you should consult a lawyer."