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Ottawa, November 18, 1996
1996-082

Changes Proposed to Expenditures Related to Tax Shelters

Related documents:

• Backgrounder.
• Notice of Ways and Means Motion and Explanatory Notes (Adobe Acrobat format - 48,427 bytes).

Secretary of State (Finance) Doug Peters today tabled in the House of Commons a Notice of Ways and Means Motion proposing changes to the Income Tax Act that affect transactions under which investors achieve tax-shelter benefits by financing the business expenses of other taxpayers in exchange for a right to receive future income. These tax shelter arrangements evolved out of provisions of general application in the Income Tax Act and were never intended as a "tax-assisted" investment incentive.

The proposed measures restrict the deductibility of these expenditures by prorating them over the economic life of the related right to receive future income.

"These measures are designed to protect the personal and corporate tax bases," Mr. Peters said.

A backgrounder explaining the proposals in more detail is attached.

References to "announcement date" should be read as referring to today's date.

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For further information:

BACKGROUNDER

Transactions under which businesses finance their operations through tax-assisted financing arrangements have grown in utilization because they provide businesses with financing that is partially subsidized by the government, that is off-balance sheet in nature and that provides investors with valuable tax-deferral benefits. The measures announced today do not preclude structures in which third parties invest in another person's business. Rather, these measures constrain the tax-assistance in such structures by matching the cost of an investor's investment to the periods during which the investment earns income. In this way, investors cannot create losses in the early years of an investment that off-set income from other sources and which would otherwise be subject to tax.

Transactions of the type affected by the amendments involve the financing of business expenses by selling those expenses to investors who derive tax shelter benefits. In these transactions, investors undertake to pay expenditures that would otherwise be expenses payable by the "vendor" (e.g., payroll, selling commissions) in exchange for a right to receive future income, usually from the vendor's operation. Many of the taxpayers that sell their expenses do so because they are not in a tax paying position (e.g., they are incurring losses) and do not need the expenses to offset taxable income, or to achieve off-balance sheet financing which, effectively, raises funds without the amounts raised showing up as debt on the balance sheet.

The reasons why third party investors are willing to assume these expenditures include the valuable tax deferral benefits that can be obtained. In this regard, the third party's expenditure is written-off much sooner than the income from the right is realized. That is to say, for the purpose of computing accounting income the principle of conservatism[1] may operate to shorten the period over which an expenditure related to a right to receive income would otherwise be amortized under the matching[2] principle.

These transactions give rise to uncertainty as to whether such expenditures are deductible for tax purposes and, if so, the appropriate matching period. Where the expenditures are deductible under the established tax jurisprudence, there is a mismatching of expenses and revenue to the extent that the portion of the expenditure deducted by a taxpayer in an early taxation year(s) exceeds revenue recognized from the right in the year(s) with the excess deduction being applied against other sources of income which would otherwise be taxable. This creates a tax shelter under which investors defer their tax liabilities. In effect, the value of the tax loss is being used to subsidize the financing of the vendor's business expenses.

Recently there has been increased pressure for transactions of this type to be applied to a broad range of businesses which would, if permitted, have significant revenue implications for the government. In response, Finance Minister Paul Martin has proposed new measures designed to restrict the deductibility of an otherwise deductible "matchable expenditure" related to a "right to receive production" by prorating the deductibility of the amount of the expenditure over the economic life of the right

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Notes:

[1] From the perspective of computing income, the expensing (in an accounting sense) of an expenditure to an income period as soon as is reasonable while revenue is not recognized until the income period in which it is reasonably certain. Note: this footnote is for information purposes only and should not be considered to be a definition for the purposes of interpreting accounting principles or the tax law.

[2] From the perspective of computing income, the apportionment of the cost of an expenditure to the income period or periods in which resulting income is recognized (i.e., the expensing of the expenditure in an accounting sense). Note: this footnote is for information purposes only and should not be considered to be a definition for the purposes of interpreting accounting principles or the tax law.