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Ottawa, August 6, 1997
1997-069

New Rules Proposed for Computer Software Shelters

Related documents:

• Backgrounder.
• Draft Amendments to Income Tax Regulations and Explanatory Notes (Adobe Acrobat format - 13,030 bytes).

Finance Minister Paul Martin and National Revenue Minister Herb Dhaliwal today issued a joint announcement that will improve the fairness of the tax system and prevent abuses related to computer software tax shelters.

Minister Martin today proposed to amend the Income Tax Regulations governing "leasing property rules" and to enact new "computer software tax shelter property rules". The "computer software tax shelter property rules" will restrict the deductibility of capital cost allowance for computer software that is not otherwise already subject to the leasing property rules; the deductibility will generally be limited to the amount of income earned by the business in which the software is used.

Mr. Dhaliwal stated that "Revenue Canada has been reviewing and auditing tax shelter arrangements, including computer software promotions, to ensure that they meet the requirements of the tax law". An increase in the auditing of tax shelters was announced by the Minister of National Revenue in a joint press release with Finance Minister Paul Martin on December 1, 1994.

Further information on the changes to the Income Tax Regulations and details of the various tax rules used by Revenue Canada in issuing reassessments is provided in the attached Backgrounder.

Reference in the attached draft Income Tax Regulations to ANNOUNCEMENT DATE should be read as referring to today's date.

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For further information:

Backgrounder

A tax shelter is any property promoted to an investor on the basis that losses or other deductions, or benefits such as tax credits or revenue guarantees, will be available to the taxpayer within four years, the total of which equals or exceeds the amount the investor pays for the property.

Potential investors in tax shelters should be cautious and exercise due diligence before investing in a tax shelter. In particular, the existence of a tax shelter registration number in respect of a promotion should not be taken as government approval for the promotion. Tax shelter selling documents are required to display a tax shelter identification number and to indicate that the identification number is for administrative proposes only and does not in any way confirm the entitlement of an investor to claim any tax benefit associated with the tax shelter. Revenue Canada uses tax shelter identification numbers to, for example, identify for audit purposes investors participating in tax shelter arrangements. It is prudent, therefore, for investors to examine all documents carefully and consult an independent tax advisor before purchasing a tax shelter. Matters that should be considered include, for example, whether the tax shelter features:

• a lack of business activity, or an activity with no reasonable expectation of profit;
• unreasonable or inflated expenses, or overvalued assets; or
• limited-recourse financing, including promises that debts will be forgiven or not be collected, or offers of financing arrangements that indefinitely defer an investor's payment.

Over the last four years, the government has implemented a number of measures countering the proliferation of transactions designed primarily to sell income tax shelters to investors, including the "limited-recourse debt" rules, the "matchable expenditure" rules and the broadening of the "minimum tax" base to include all tax shelter losses. Nevertheless, the government remains concerned about "computer software tax shelter promotions" being marketed to investors. In particular, computer software tax shelters registered under the "tax shelter identification rules" exceeded $1 billion in 1996 with $190 million in actual sales. A typical software tax shelter is as follows:

Revenue Canada Audits:

Concurrent with the announcement of the "limited-recourse debt" rules on December 1, 1994 (Press Release 94-112), the Minister of National Revenue indicated that Revenue Canada would increase its audits of "computer software" tax shelter promotions. In audits completed to date, Revenue Canada has identified a number of non-compliance issues with these tax shelters with resulting reassessments in excess of $20 million. As well, audits involving up to $230 million in computer software tax shelter losses are in various stages of progress.

Losses in respect of these tax shelter promotions are normally not deductible, in whole or part, if:

1. The proposed activity does not have a reasonable expectation of profit;
2. The value of the software is inflated or unreasonable;
3. The notes payable as part of the purchase price are not genuine, are contingent liabilities, or their value is inflated;
4. The investors claim losses for which they are not truly at risk;
5. The tax shelter promotion does not comply with the capital cost allowance leasing property rules that preclude capital cost allowance claims that would otherwise create or increase an investor's loss;
6. The software has not been acquired by the entity in question or it is not available for use in the relevant taxation year;
7. The tax shelter was sold before a tax shelter identification number was obtained by the promoter; or
8. The general anti-avoidance rule (GAAR) applies to the tax shelter promotion.

Some computer software promotions are currently being marketed to investors on the assumption that the computer software will be used to produce non-software products for sale rather than to earn rent, royalty or leasing income from the licensing or distribution of copies of the software (i.e., marketed on the basis that the property is not "leasing property"). Even in cases where the software is not a leasing property, however, the other above-mentioned non-compliance issues may arise during the course of an audit and result in a reassessment of an investor's tax return.

The changes in the Income Tax Regulations proposed by the Minister of Finance will resolve disputes on many of these issues for the future by, in effect, extending stop-loss rules similar to the leasing loss rules to all computer software tax shelters regardless of whether the computer software comes within the conventional concept of "leasing property". In this way disputes between Revenue Canada and taxpayers on the effectiveness of these tax shelters will be reduced and potential investors will be protected from those promoting computer software tax shelters which are determined to be ineffective under the tax law.