A.K.A. How amateur athletes got bad tax advice and how you can avoid their fate!
Canadian Tax Haiku of the Month:
Saving taxes through
needs legit intent
Recently, The Star highlighted two professional athletes that were caught up in a tax plan that resulted in a $2.3 million and a $750,000 tax bill to the CRA through formal proposals in settle under the Bankruptcy and Insolvency Act.[i] The basis of the article is that under current income tax rules, amateur athletes can put any monies earned by them, e.g. prize money and endorsement deals, in a “Amateur Athlete’s Trust” to defer paying tax on those funds. This both offers a tax-saving opportunity but in addition (and perhaps more importantly) it preserves the athlete’s eligibility to compete at the amateur level. The funds in the trust only become taxable once the money is withdrawn. This is notable, as pulling money from an amateur athlete trust is taxed at the highest possible rate when it comes out. That is to say that the totality of the funds would be subject to a 48% combined federal and provincial rate in Alberta and 53.53% combined federal and provincial rate in Ontario.[ii] So, upon withdrawal of the funds, the athlete would lose half of the money upfront.
Understandably, amateur athletes are incentivized to plan around these rules. The article discusses how a Toronto lawyer (DEFINITELY NOT ME!!!) set up a structure whereby the plan was as follows:
By making a donation to the charity and having the charity donation to the university, the structure intends to take advantage of one of the four traditional heads of charity – advancement of education being the one at issue here.[iii] The effect of the plan would be that the amateur athlete would be able to claim a charitable tax credit on their personal return for the year the funds were withdrawn, nullifying much if not all of the income tax payable on the withdrawal of the funds from the trust. Consequently, because the death benefit of a qualifying life insurance policy are tax-free, the whole idea is to wash the money via the “charity” and “university” and put it back in the hands of the original owner (i.e. the athlete) without tax.
The Problem with the Structure
While we have to give the tax lawyer in question some props for being innovative, the plan stinks, and simply does not work. However, the issue is not with the life insurance policy – unless it is not Canadian compliant. The issue is with the so-called “charitable donation”. There was absolutely “charitable intent” as the objective was clearly to do a business transaction with tax benefits. The university was not the end beneficiary of the donation but rather acting exclusively as an agent for the transaction and taking a cut off the top. (See our other blawgs on this issue here: http://www.dominiontaxlaw.com/cra-crackdown-on-the-political-activities-of-charities-well-founded-and-fundamentally-pro-democracy/) As a result, the charitable donation credits would not pass muster.
Furthermore, the charity that flowed the donation through to the university would also lack the requisite charitable purpose under subsection 149.1(1) of the Income Tax Act. As discussed in AYSE v CRA (2007), a charitable organization must devote all of its resources to “charitable activities carried on by the organization itself”.[iv] The court further elaborates and describes that “it is really the purpose in furtherance of which an activity is carried out, not the character of the activity itself, that determines whether or not it is ‘charitable’”.[v] In this instance, the charitable donation to the “university”, while a donation in and of itself, the ultimate purpose was to gain a tax advantage through the purchase of the life insurance policy. The purpose of the activity would not meet the description set out in AYSE. This being the case, the charitable donation would fail the common law requirements of a charitable purpose under subsection 149.1(1).
There is also an issue regarding the “General Anti-Avoidance Rules” (GAAR) under subsection 245(2) of the Income Tax Act. GAAR says that if there are a series of transactions with a foreseeable outcome, and the “principal purpose” of one or more of those events is to obtain a tax benefit and said transactions amount to a “misuse or abuse of the Act”, then it is all undone under the GAAR provision of the Act.[vi] It can be argued that the abuse is the use of the charitable provisions and the exempt policy rules to obtain the eventual tax-free benefit and it is therefore off-side.
So Does That Mean All Offshore Insurance Structures are Bogus?
Not at all. Indeed, offshore life insurance is a growing market for Canadians with substantial means, particularly if they are sitting on bankable assets [footnote as bonds, stocks, mutual funds GICs and other assets that can be held by a financial institution in an investment account] . Suppose there is a taxpayer who owns a owner-managed business and they have the standard Operating Company (“OpCo”) owed by a Holding Corporation (“HoldCo”) structure. The business owner has retained a lot of earnings in the HoldCo, duly paying dividends of tax-paid profits up from their OpCo every year, and HoldCo then holds the retained profits in an investment account in Canada. Given the recent changes to the rules with regard to passive income earned by corporations, the owner faces the same situation as the amateur athlete – adverse tax consequences for holding the bankable investment assets in the HoldCo, and even worse consequences in the on withdrawal of the funds from the corporation.
To address this issue, we would propose creating a tax structure as follows:
1) Take corporate tax-paid funds from the HoldCo and settle it in a trust offshore. As the transfer from the corporation to the trust offshore is a deemed disposition, capital gains tax is payable on that transaction, so the funds in the trust are tax-paid, with no attempt or effort to reduce that tax. It is what it is. It has to be paid sooner or later, and our advice is just to “rip the band-aide off” and pay the capital gains tax at a maximum of about 12.5% in the corporation. The best way to begin any structure is to simply pay the upfront tax and be done with it.
2) Use tax-paid funds in the trust to buy a life insurance policy on the life of the key person (business owner) owned by the Trust with its beneficiary as HoldCo. This insurance policy would not include relatives, only key person to the business.
For a Canadian resident, there is no “tax benefit” because you could always buy a domestic life policy (more cost, far less death benefit) or invest in non-taxable investments like stocks that pay no dividends. So where is the tax benefit? The principal purpose of the trust is to allow access to global capital markets, not to be stuck with the domestic Canadian banking oligarchy. Canadian taxpayers who have used our structure have seen their asset management fees, even after trustee fees, cut almost in half just by moving their assets offshore. The principal purpose of the life insurance is there to protect the value of the corporation and to protect the taxpayer’s heirs. The tax benefits of throwing off no taxable income are secondary, if they technically even exist at all.
Lastly, the business-owner will eventually retire in the future and the trust, in the future, could potentially borrow money against the policies and could, potentially, in the future at some unknown point, lend money to the HoldCo, which could pay the taxpayer a pension or dividends in retirement. However, the taxpayer will not longer benefit from the money personally. The insurance policy only pays when he or she dies. This results in “no benefit” to the taxpayer personally. The corporation will benefit and the trust will benefit from the policy, and both will pay off their debts, but only after the taxpayer passes away. An added benefit is that if there is anything left, it will flow out to the taxpayer’s estate tax-free as a capital dividend from the capital dividend account.
It is unfortunate what happened to both Mr. Donovan Bailey and Ms. Pace Lindsay with regards to the tax planning advice they relied on. The result of over-aggressive tax planning can catch those who do not necessarily have the financial literacy to question the advice that they are relying on from their trusted advisor. One of the things I always say is never trust a tax planner who does not litigate tax matters as well. Pure planners seem to have this attitude sometimes that “oh yeah, that seems logical”; or “the CRA will never figure this out” or “the tax court judge will buy that”. Umm… no. The CRA is not stupid and tax court judges have great BS detectors. They used to be tax lawyers themselves, so it is impossible to put one over on them. The plan has to make sense and not rely on the stupidity of others.
The rules regarding charitable donations and General Anti-Avoidance under the Income Tax Act are set out to prevent abuses of the system and it is very regrettable that a fellow tax lawyer had used their knowledge irresponsibly. As the great sage Ben Parker once said, “with great power comes great responsibility”.[vii]
But it is important not to throw the baby out with the bathwater. With some careful and defensible tax planning from a litigating tax lawyer, offshore insurance structures can be very useful and effective, and this type of situation can be avoided.
This Blawg is provided on a “For your information” basis only, and is not intended as, does not constitute and should not be seen as legal advice with regard to tax or family law matters.
Jonathan N. Garbutt, Barrister & Solicitor
Justin N. Pon, Student-at-Law
[iii] The Income Tax Act does not sufficiently define what is or is not charitable for the purposes of subsection 248(1) or subsection 149.1(1) which both uses the term “charitable”. This being the case, the CRA has relied on the common law definition of charity which was set out in Commissioners for Special Purposes of the Income Tax v. Pemsel,  A.C. 531 (P.C.) and later affirmed by the Supreme Court of Canada in Vancouver Society of Immigrant & Visible Minority Women v. Minister of National Revenue,  1 S.C.R. 10. It defines the “four heads of charity” as i) relieving poverty, ii) advancement of education, iii) advancing religion, and iv) other purposes beneficial to the community in a way the law regards as charitable.
[iv] A.Y.S.A. Amateur Youth Soccer Association v. Canada (Revenue Agency),  3 S.C.R. 217, 2007 SCC 42 [AYSA].
[vi] Income Tax Act, RSC 1985, c 1 (5th Supp), s 245.
[vii] Stan Lee, Amazing Fantasy (New York City: Marvel Comics, 1962)