Tax Forum
Art Flip Schemes
Savvy investors are well advised to be aware of art flip schemes, which can end up costing much more than the tax savings they promise.
FROM:
JUL-AUG 2004 ISSUE | BY
DON GOODISON
If something seems too good to be true, it usually is, especially in the world of taxation. Most schemes that promise huge tax savings for little or no investment are invariably revealed as scams once the Canada Revenue Agency hears about them. While less common than they once were, there are still some of these schemes around, and unwary taxpayers are still falling victim to them.
In
Frank Klotz, Appellant vs. Her Majesty the Queen, Respondent; 2004
TCC 147, the Tax Court of Canada examined what is known as an “art flip” scheme. As part of a program called Art for Education, Klotz purchased 250 original prints, which he then donated to Florida State University. In exchange for his donation, Klotz received a receipt for $258,400, which he then claimed as a charitable donation on his income tax return. For purposes of the donation, each print was appraised at approximately $1,000.
Since the prints were considered personal use property, and such property is deemed by
subsection 46(2) of the
Income Tax Act to have an adjusted cost base of the greater of $1,000 or the adjusted cost base, any capital gains on the disposition of the prints was eliminated. The Minister of National Revenue disallowed the claim, however, on the basis that the value of the donated prints was, at most, $300 per print, for a total of
$75,000 — which is how much Klotz actually paid for
them — and that the prints did not constitute personal use property. The minister also imposed penalties for gross negligence.
Klotz was one of 660 individuals who participated in the Art for Education program, which was promoted by an Ontario corporation. The corporation retained an individual to acquire prints from artists and dealers, and who was instructed to pay no more than $73.50 ($50US) per print. Most of the prints were purchased for this amount, though some cost as little as $7.35 ($5US).
The prints were then sold to people such as
Mr. Klotz for $300 each, with the promise that the donation would result in substantial tax savings. Klotz never saw or took possession of the prints, nor did he know what Florida State University was planning to do with them. Among the promotional materials for the scheme were opinion letters from two
well-known law firms, which had been carefully drafted to avoid giving any tax opinion of the scheme. Subsequent to the donation, Klotz was also provided with an appraisal showing the value of the artwork to be $265,900, an even greater amount than was listed on the donation receipt.
Klotz appealed the decision to the Tax Court of Canada, whose sole task was to assess the valuation of the prints. If the valuation that Klotz had received was accurate, the value of the donation would be correct, and no penalties assessed. An expert called by Klotz as a witness to verify the appraisal of the prints was only able to provide a lukewarm endorsement, stating that the appraisal report was reliable in substance but had a number of inadequacies, and he made it clear that he did not endorse its conclusions.
In his reasons for judgment, the judge likened the testimony of the expert to “damning with faint praise.” The judgment went on to examine portions of the appraisal, and then rejected it on the basis of a number of factors. The judge ruled the fair market value of the prints was $75,000, the amount Klotz paid for them. He dismissed the minister’s claim that the prints were not personal use property, and also dismissed the penalties for gross negligence, essentially granting Klotz’s appeal.
It is difficult to cast Klotz as a victim in this situation: as the senior
vice-president of a corporation, he evidently possesses a sound understanding of financial matters, and his reason for becoming involved in the scheme was strictly for profit at the expense of Canadian taxpayers. However, he was subject to unscrupulous behaviour on two fronts. First, by the promoters of the scheme who used devious means to get Klotz to part with
$75,000 Cdn. The promoters paid approximately
$73.50 Cdn per print, and cleared a profit of $176.50 per print, or $52,950 total. If all 660 individuals that took part in the scheme invested the same amount, the promoters realized a total profit of
$34,947,000 — not too shabby.
Second, Klotz became involved in the Art For Education program on the advice of his financial advisor, who failed to inform Klotz that the promoters would pay him 10 to
15 per cent of whatever Klotz invested. To me, this is highly unethical, and is a conflict of interest. Anyone who stands to benefit from a client’s participation in any sort of venture should make full disclosure of that benefit and recommend that the client obtain independent advice. While the promoter and financial advisor sat back with their “winnings,” Klotz was left holding the bag. While he could be seen as a victim of his own greed, he is nonetheless a victim.
This particular case did not deal with another aspect commonly seen in art flip schemes. A few years ago, a
non-profit client of our firm was approached by a group willing to donate $450,000 worth of artwork in exchange for a receipt. The value of the artwork was supported by an appraisal in excess of $450,000. Like many charitable organizations, they were somewhat strapped for cash, and so they accepted the deal. They took possession of the prints and proceeded to try to sell them. Unfortunately, the prints proved to be almost worthless, and the client ended up writing them off. While they had not lost any cash, a lot of their future plans had been based on the $450,000 profit they would reap from selling the prints. Further concerns were added by the government announcing that charities that participated in art flip schemes risked losing their charitable status, a potentially devastating price to pay for an opportunity that turned out to be too good to be true.
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Don Goodison, CFP, FCGA, is a partner of Kemp Harvey Goodison, Certified General Accountants, in Burnaby, B.C. E-mail
goodison@axionet.com.