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October 1997

Computer Software Shelters Under Attack

By Howard Berglas, CA

Reducing taxes through the use of tax shelters has become more and more difficult over the years. Recent legislative changes and more vigilant scrutiny of tax shelters by Revenue Canada have now led to all out war. In addition, the multitude of reassessments has most certainly led to a decline in the appetite of the average Canadian to get involved.

First it was real estate. Now during the past few months, we have witnessed a concerted attack on computer software tax shelters! The objective of the attack is to generally deny all of the deductions claimed, using the following arguments:

  • There was no reasonable expectation of profit.
  • The software was grossly overvalued.
  • Deductions cannot exceed income from the software.
  • The software was acquired with a contingent liability.
  • The assets acquired were not software but copyrights.

Revenue Canada's disdain for computer software tax shelters seems to stem from their experience with auditing certain ventures that border on being fraudulent. In particular, we have heard of one tax shelter in which a quick flip of software was made to an offshore entity at a price that was over 30 times the price paid by that entity just a few months earlier!! Needless to say, the offshore entity was resident in a tax haven, so its enormous profit went untaxed.

Most software tax shelters were structured so that the investor was only required to come up with cash of approximately 30% of the cost of the software, with the balance payable, by way of notes, ten to twenty years later. Revenue Canada believes that in many cases the balance will never be payable. Here's the way Revenue Canada sees it: (See illustration)

From Revenue's perspective, this is enough to conclude that the deals are all purely tax motivated. Then out marches the reasonable expectation of profit test. Where the investor can show that the main motivation for the investment was to earn a profit, and this expectation was reasonable, there should be no problem. After all, the Federal Court of Appeal in Tonn, deciding in favour of the taxpayer, cited, with approval, the following comments made in Nichol v. Queen:

"Mr. Nichol made what might, in retrospect, be seen as an error in judgement but it was a matter of business judgement and it was not one so patently unreasonable as to entitle this Court or the Minister of National Revenue to substitute its or his judgement for it, or penalize him for having made a judgement call that, with the benefit of 20/20 hindsight, that Monday morning quarterbacks always have, I or the Minister of National Revenue might not make today." However, where the underlying business integrity of the deal is called into question, be prepared for a rough ride.

We have been engaged by over 300 investors in various computer software tax shelters to represent them in their fight against Revenue Canada. We will update you as the events unfold. Meanwhile, if you own a computer software tax shelter, you are almost certainly going to be reassessed. Unfortunately, as with real estate tax shelters, the good, the bad, and the ugly all get tarred and feathered with the same brush.