Inflated asset values can cause tax time issues

“The very term ‘Arabian horses’ takes me back to the early 1960s, watching in awe as Lawrence gallantly galloped across the Arabian sands on a sinewy strong stallion. The power, the grace, the beauty — it was unforgettable.” – Honourable Justice Campbell J. Miller (Teelucksingh v. the Queen)

It seems almost a shame to introduce such eloquent prose into a discussion of taxes. But so began the judgment in the case of Teelucksingh v. the Queen, which dealt with a suspect tax plan. The whole affair was a horse race that spanned 18 years since first assessment. After 11 days in court, the taxpayer appears to have nosed out the Queen at the finish line.

The plan is conceived

The genesis of the tax plan in this case was the financing of a herd of Straight Egyptian Arabian horses. To build a herd large enough for a viable business venture, Montebello Farms needed to raise cash, and it struck upon the idea of pooling disparate investor funds through the use of a limited partnership structure.

Using example numbers detailed in the judgment, the key events in the arrangement were as follows:

Under an Offering Memorandum, an investor borrowed $18,000 from Montebello to acquire a limited partnership interest and common shares in a corporation. At closing, current and prepaid expenses (including horse inventory) led to a farming loss distributed at $9,520 per unit, some usable that year and the rest carried forward.

Following closing, the partnership transferred the assets to the corporation in exchange for preferred shares, which were distributed to the limited partners about 45 days later upon planned dissolution of the partnership.

The preferred shares were structured to qualify for deposit into the investor’s RRSP, which at purported fair market value allowed for a swap-out of $18,236 in cash, the bulk of which was then used to retire the Montebello loan.

Dividend payments of $45,000 were made in each of the two following years, after which the corporation was dissolved.

A bump in the road

Mr. Teelucksingh was one of hundreds of Montebello investors that the Canada Revenue Agency reassessed. He participated in two Offerings, commencing in 1993 and 1995, respectively. In 2001, the CRA reassessed him, denying the restricted farm losses and treating the RRSP transactions as taxable withdrawals.

On appeal at the Tax Court of Canada, the judge makes it clear that the case “is about the tax consequences of the investing arrangement more than about the intricacies and complexities of the horse business.”

The result would turn on the legitimacy of the partnerships, the valuation of the horses, and the reasonableness of two years’ prepayment of expenses.

Down to the wire

Interestingly, the judge did not find fault with the bona fides of the partnership or with the complex series of transactions. His only reservation was “the inflated value of the horses.” Caught between optimistic and pessimistic expert testimony on either side of the dispute, the judge arrives at a compromise valuation for the horses at something that is less than half of the original values.

As to the prepayment, he stated, “While I have some concern as to the commercial reasonableness of such a prepayment provision, I have nothing concrete upon which to substitute my judgment for the partnership’s judgment.”

Thus, almost two decades after supporting the herd, Mr. Teelucksingh will finally be able to enjoy both the farming losses and the RRSP gains — though, unfortunately, not as lucratively as he initially projected.

Doug Carroll JD, LLM (Tax), CFP, TEP, is vice president of tax and estate planning at Invesco Trimark Ltd.