Tax shelters: seeking shelter from the tax man.
One tax term that comes up at this time of year is tax shelter. A tax shelter does just what the term implies -- it shelters your other income from income tax. You, as the purchaser of a tax shelter, are entitled to a tax deduction equal to either a portion or the entire amount of your investment in the tax shelter. The tax deduction reduces your other income otherwise subject to tax, in effect sheltering that other income from tax. In addition, like any other investment, a tax shelter usually earns income, and this income is subject to tax as it is earned.
RRSP as a Tax Shelter
Although perhaps not usually thought of as a tax shelter, contributing to an RRSP is, in fact, the best known and most popular tax shelter. Contributing to an RRSP may not elicit the kind of excitement that other tax shelters do, but most of us should consider maximizing our contributions to an RRSP to be one of the most important ways of sheltering our income from tax.
Evaluating A Tax Shelter
There are a number of sophisticated tax shelters that are usually aggressively marketed by their promoters. The promoters generally target taxpayers who are already paying income tax at the top tax rate, have maximized their RRSP contributions, have additional cash to invest, and are willing to assume a high level of risk. Although the marketing of a tax shelter usually concentrates on the tax savings aspect of the shelter, it is vital that you, as a prospective purchaser of a tax shelter, look first at the economics and feasibility of the investment behind the tax shelter. Tax shelter investments are usually highly risky and often do not achieve their forecasted results. A good rule of thumb is that if a tax shelter is not a good investment ignoring the tax savings, the tax savings will not make it a good investment.
One good example of looking at the quality of the investment rather than the tax savings is to look at the most commonly used tax shelter -- the RRSP. An RRSP contribution provides a tax deduction to the purchaser equal to the amount of his or her contribution and thus provides immediate tax savings. However, it is the return that the investment generates until retirement that is paramount to the objective of the objective is to provide a source of RRSP. The objective is to provide a source of income on retirement.
You should always seek professional advice before purchasing a tax shelter. A professional advisor can help you understand the economics and the tax implications of the investment. It is important that you consider the many tax rules that can prevent you from being able to fully claim the tax benefits built into a tax shelter. In addition, you should review the reputations of the parties behind the tax shelter.
Revenue Canada Attacks on Tax Shelters
The number of tax shelters has declined significantly over the past fifteen years with the gradual introduction by the federal government of more and more tax rules to combat what it sees as abuses of the tax system by tax shelters. The rules include specific reporting requirements for disclosure of tax shelter deductions on your personal tax return that make it easier for Revenue Canada to identify and audit tax shelter deductions. You should also ensure that the tax shelter has an identification number with Revenue Canada. This means that the shelter has been properly registered with Revenue Canada; it does not mean that Revenue Canada has approved the deductions being claimed.
Tax Shelters Today
The most common tax shelters in recent years include investments in films, computer software, mutual fund fees, resource activities (oil and gas, mining and renewable energy), and e-commerce. Rules introduced over the past several years by the federal government have gradually closed down many tax shelters. This article describes two tax shelters that have not yet been closed down -- resource activities and e-commerce.
One of the most common tax shelters today is an investment in resource activities, specifically in oil and gas, mining, or renewable energy. This tax shelter is structured as an investment in either flow-through shares of a company or a limited partnership.
The main advantage of flow-through shares is that they allow a company engaged in resource activities to incur expenses, and then, rather than claiming the tax deductions itself, flow the deductions through to the investor who claims them. As a general rule, the shares are considered to have a cost base of zero. Thus, when the shares are sold, a capital gain results equal to the entire proceeds received on the sale.
The expenses incurred by the resource company that can be flowed through to an investor are exploration and development expenses incurred in Canada. Generally, the expenses incurred are fully deductible to the investor in the same year that they are incurred by the company. Many other tax shelters require an investor's deduction to be spread over two or more years, and so a tax shelter investment in resource activities can be very attractive.
When evaluating a prospective investment in flow-through shares, you should examine the company issuing the shares and the related resource property that is the subject of the expenses. It is also important to consider the after-tax cost and after-tax return of the investment. For example, if you pay $10,000 for the purchase of flow-through shares and receive an immediate tax deduction of $10,000, you will save approximately $4,000 in tax (if you are taxed at the top tax rate in Alberta, for example) for an after-tax cost of approximately $6,000. In order for you to break even on your investment, you must sell your flow-through shares for approximately $7,500 to have $6,000 in cash after you pay the approximately $1,500 of capital gains tax.
A resource tax shelter investment can also be structured with you, the investor, being a partner in a limited partnership. You report, on your tax return, your share of the partnership's income and expenses, including resource exploration and development expenses incurred by the partnership.
A resource limited partnership tax shelter is sometimes structured so that the partnership eventually sells its interest in the related resource property to a private compan5 with the partners receiving shares of the private company. Eventually, the partners may sell their shares of the private company to a public company, so that they realize capital gains from the sale of the shares. The capital gains may be fully exempt from tax under special rules that allow investors in certain private companies to realize up to $500,000 of capital gains on a tax-free basis.
E-Commerce Limited Partnerships
One of the newest tax shelters is an e-commerce limited partnership, through which a retail company uses a limited partnership to finance the e-commerce portion of its business. The limited partnership develops an e-commerce business for the retailer's products by developing a web site, selling products via the Internet and possibly financing the sale of products. You, as a partner who has invested in the partnership, report your share of the partnership's net income or losses on your personal tax return.
An e-commerce limited partnership may be structured so that the partnership eventually sells the e-commerce business to a private company in exchange for the partners receiving shares of the private company. Eventually, the retail company may acquire the shares of the private company from the partners so that they realize capital gains from the sale of the shares. Again, these capital gains may be fully exempt from tax under special rules that allow investors in certain private companies to realize up to $500,000 of capital gains on a tax-free basis.
The federal government has gradually introduced tax rules over the past several years that have significantly reduced the number of tax shelters being marketed. If you are considering an investment in a tax shelter, you should always consider maximizing your RRSP contribution to be your most important tax shelter. If you still have excess cash to invest, you could consider an investment in another tax shelter. However, you should always seek professional advice before purchasing a tax shelter, and you should look first at the quality and risks of the investment and not at the tax savings.
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|Date:||Feb 1, 2001|
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