Skating on Thin Ice - Charitable Transactions that Draw the Tax Man's Attention

Reference Number
CES - 013

Date
December 8, 2000

Introduction

1. The subject matter of my presentation to you today - Skating on Thin Ice - was first broached by Carl Juneau, Director of Policy & Communications in the Charities Directorate, in February 1999 at a Conference directed mainly at religious organizations.¹ At the time, there was a local Ottawa story making national headlines, and the two words he offered to summarize public concern about tax receipted gifts were "Alexei Yashin". If you'll recall, in early 1999 Alexei Yashin was making headlines in the Ottawa press as a result of an arrangement that apparently transpired between himself and the National Arts Centre - and coincidentally it is strangely appropriate in the light of the title of today's presentation.

2. It would not be proper for me to comment on the legality of Mr. Yashin's arrangement with the National Arts Centre. As an official of the Canada Customs and Revenue Agency, whatever tax information I might have on the arrangement is confidential between the taxpayer and the Canada Customs and Revenue Agency (Canada Revenue Agency), as is proper to a tax administration.

3. There are probably some aspects to the Yashin incident that the media might not know, and I'm not implying that Mr. Yashin was right or wrong in the case, or that there is an absolute comparison between Mr. Yashin and any other donor.

4. But what's useful to grasp here is the range of the public reaction to the incident. It gives us an idea of the temptations that can arise with gifts and tax-receipting, and it shows that the ethical or legal boundaries that we set around the notion of giving may not be - contrary to what some people would like to claim - an exercise in arbitrary by the tax administration. There is at the very least a generally accepted notion of how people should behave in giving, and how and why people should give.

5. The purpose of my presentation today is to give you some idea of those areas of charitable giving where the tax administration frequently has concerns.

6. The notion of a gift for tax purposes is defined at law. Generally, a gift is a voluntary transfer of property without consideration. I won't expound on that further. The definition is discussed more fully in a number of departmental publications, notably Interpretation Bulletin IT-110R3². Neither am I going to dwell on gifts between registered charities and other qualified donees - these have to meet somewhat different rules. But beyond this, what kinds of gifts does the Canada Revenue Agency worry about? When someone gives to a charity, what triggers closer scrutiny by the Canada Revenue Agency?

Kinds of gifts

7. It is fair to say that the Canada Revenue Agency will want to ensure that donors generally comply with the definition of giving. But certain patterns of giving are of definite concern, because the transactions are substantial, and because our audits have uncovered either significant abuse or the potential for abuse. This abuse has an impact not only on lost revenues for state coffers but also for the charities that the transaction, on its face at least, intends to benefit.

8. The whole area of directed gifts is of concern. Not so when the donor's wish is to apply the gift to a particular project of the charity. It is of concern when the gift is expressly or implicitly structured to provide a direct and private benefit back to the donor, or to persons in whom the donor has a personal interest. These kinds of transactions vary greatly in terms of their sophistication. They can range from loan-backs, where the donor for instance makes a large contribution to a charity on the condition that the charity reinvest the funds in enterprises controlled by the donor, or situations where the payment is made to the charity as long as a donor's relative is the main beneficiary.

9. Transactions like this can deprive the charity from its ability and indeed its ethical or moral duty to invest or run its programs wisely. To what extent can or should the state intervene in cases like this and substitute its own judgment for that of the donor or the charity? Nevertheless, there have been cases where the donor has benefited from a substantial tax advantage, and where the investment for instance back into the donor's enterprise eventually goes sour. A charity can shrug off a minimal return on such an investment by saying that $1 dollar out of $10 is better than nothing at all. It's sad to say that we hear this argument often. Such thinking is tempting in today's world, where competition between charities for donation dollars is more and more intense. But has the charity really won? The state coffers have certainly lost, and in the final analysis, haven't we all lost, as taxpayers and as a community, at the expense of private gain.

10. Government brought in legislation three years ago to try and shut down the most underhanded schemes - those where for instance the donor also controlled the charity and accordingly was able to postpone repayments or interest payments indefinitely³.

11. Luckily, community charities are more circumspect about these things, and less likely to engage in arrangements that ultimately compromise program growth and delivery. Nevertheless, the problem of donor benefit still crops up. It is less offensive where the donor to a university gets the library named in his or her honor. It is more offensive when, as a condition of the gift, the donor gets to influence the course curriculum or determine which brand of equipment the charity buys. How does that affect the kind of education or the kind of hospital care that we get? When these things happen, the only recourse that a tax administration or indeed the community has is the notion of a gift: a voluntary transfer of property without consideration. To what extent did the promise of a seat on the board of directors or a contract with a specific pharmaceutical company, or travel for a son or daughter bring the donor to pay?

12. As well, the phenomenon often goes beyond tax administration, when it doesn't involve giving, or a tax receipt - nor is a tax administration the appropriate regulatory body. This can be a pure business arrangement: Corporation X pays for the lab equipment, and in return it has the exclusive rights to vending machines. And there is probably a lot of room here for ethics and self-regulation.

13. Closer to tax matters, one area that the Canada Revenue Agency is particularly concerned about is gifts of art. Not that giving art to a museum or for a charity auction is a bad thing. But what we are seeing is that the art is often substantially over-valued. Sometimes, it's garbage. I know of a particular case for instance where our auditors went and inspected the artworks, and found one in particular with a neat crease down the middle, and staple marks from its former existence as a magazine centerfold. Frequently, the donor doesn't even see the art. An art dealer approaches and convinces the donor that an advantageous tax receipt can be garnered by purchasing a painting at a bargain price, and then donating it to a willing charity for a substantially higher and presumably "true" value.

14. The attractiveness of this kind of scheme is that none of the immediate parties to the series of transactions is a loser. The artist - presuming that the art is legitimate - gets to sell his inventory. The donor gets a tax credit that is substantially higher than his purchasing costs, and the charity gets at least some return on the sale of the art. Sure, the disproportion between the amounts for which the charity has issued tax receipts, and the re-sale value of the artwork, if any, can affect the charity's disbursement quota. This has happened, but it's not always the case. The real loser here is the state, and ultimately those taxpayers who have to pay because - relatively speaking - someone wanted to get something, for having given nothing.

15. There are cases where art is legitimately obtained at bargain prices and where its value increases, and the donor gets a legitimate windfall in terms of a greater tax advantage. The Canada Revenue Agency has won and lost some cases in this area. What is important is that the provisions against art scams, intended to shut down abusive practices, are now law.⁴ This legislative amendment (Misrepresentation of a Tax Matter by a Third Party) was passed as law on June 29^th of this year as part of Bill C-25. The penalties will likely affect the donor, the promoters, the appraisers and the charity.

16. Another area of current interest for the Canada Revenue Agency and Finance Canada are charitable remainder trusts and gifts of residual interest. I use the two terms synonymously here, although there are slight differences between the two⁵. Essentially what happens, for example, is that the donor constitutes a trust to which he gives shares. The trust pays the interest income to the donor, and at the donor's death or after a certain term, the capital of the trust goes to a charity⁶. The donor can benefit from a tax receipt and a resulting credit at the time the shares vest into the trust. This type of deferred giving (getting a tax benefit now for a gift later) carries with it a host of problems, which have not been fully addressed yet, but which are both in the interest of the charitable sector and the Canada Revenue Agency to resolve. First and foremost are valuation problems: how does one reasonably determine the value of the residual interest at the arrival of the term? Does one use Canadian Life Tables, Annuity Tables, or Life Insurance Mortality Tables? Donors are known to shop for the most favourable rates, and it is tempting for a needy charity to acquiesce to a better if more distorted rate to bring the donor to give.

17. Also, who is responsible for insuring the trust property? As well, since there are no rules against trustees converting trust assets, how do we prevent the assets from being degraded over the course of the trust's term such that the charity actually receives less than what was originally intended? How can the charity ensure the proper administration of the trust if it cannot access trust property?

18. The Canada Revenue Agency and Finance have embarked in a series of consultative meetings with leading sector organizations on this issue. The purpose is not to shut down charitable remainder trusts - as a legitimate fund-raising tool, they are here to stay. But the purpose is to come up with legislation and policy that benefit and protect both the sector and the fisc.

What draws the tax man's attention?

19. It's important to say here that what triggers the Canada Revenue Agency's attention is not necessarily conspicuously devious behaviour. But in uncovering tax abuse, we recognize that people usually behave in certain predictable ways that are consistent with their income and their overall lifestyle. We are also aware of the equation that results in tax abuse or abuse of charitable dollars: fraud = need + opportunity.

20. Moreover, it is obvious that the tax administration would be concerned about important leakage, as opposed to relatively smaller amounts. It's natural therefore that we tend to hone in on indications of large gifts. It's not to say that we don't sweat the small stuff, but it usually gets handled in other ways - through random audits, through informants, or through our monitoring of fund-raising approaches. We tend to track the media. We often go on the Internet to look at fund-raising Web sites. We react to unusual patterns of giving or inconsistent reporting. We react to consistently large donations in relation to the taxpayer's income.

Conclusion - Overall Philosophy

21. I have to stress that the following is a personal attempt at expressing the departmental instinct. It has not found its way into official policy pronouncements, but subject to the proper application of the law, it is probably a good description of the "smell test". To sum it all up, a good guideline to determining whether the Canada Revenue Agency is concerned about a particular tax receipted transaction is:

Given the monies that are eventually applied to charitable programs and given the foregone revenues for the state, is the transaction under review intended primarily for the public good or does it result in a disproportionate benefit being given to a private individual?

22. Thank you!

1. Is the Sky Really Falling? Revenue Canada's Position on Donor Benefits and Christian Charities, Church and the Law Conference, Bramalea, Ontario. February 3, 1999.
2. IT-110R3 - Gifts and Official Donation Receipts, Revenue Canada, Income Tax Interpretation Bulletin, June 20, 1997.
3. Non-qualifying securities. See ss. 118.1(13) I.T.A. and ff.
4. Misrepresentation of a Tax Matter by a Third Party. See ss. 163.2(10) I.T.A. on Valuations, tabled as law June 29, 2000. This provision applies civil penalties to third parties that make false statements or omissions in relation to tax matters. In particular, it is intended that the penalty apply to a person who plans, promotes or sells an arrangement that the person knows or would have known includes a false statement that could be used for tax purposes. The penalty would be the greater of $1,000 or 100% of the gross revenue derived by the person from the arrangement, and would apply to the promoter of an art donation scheme, the appraiser, and in some cases where the charity knew or ought to have known of the arrangement, to the charity itself.
5. Residual interest usually refers to a gift of art or property. Charitable remainder usually refers to the equitable interest in a trust. Equitable interest in a trust = interest of a beneficiary, as opposed to a trustee, who has a legal interest in a trust. The term "charitable remainder trust" is of foreign coinage, coming to us from the American fund-raising industry. It is found nowhere in the Income Tax Act or in departmental publications.
6. IT-226R, Gift to a Charity of a Residual Interest in Real Property or an Equitable Interest in a Trust, Revenue Canada Interpretation Bulletin, November 29, 1991.