Tax Litigation In the New Economy

• Author: Arthur Cockfield
• Profession: Professor
• Pages: 548-566

Chapter Twenty

Tax Litigation in the

New Economy

Arthur J. Cockfield

A. INTRODUCTION

This chapter surveys a number of emerging litigation concerns within the

new economy. Three main factors are driving these concerns: (a) the

increase in the sale or exchange of intangible goods and services; (b) the

rise of e-commerce and the increased reliance on computers and comput-

er networks to enable commercial activity; and (c) an increase in cross-bor-

der economic activity by individuals and small to medium-sized firms.

The chapter initially focuses on valuation issues for software tax shel-

ters and the judicial response thus far to these developments. Next, the

chapter discusses recent changes to the OECD model tax treaty that permit

countries to tax profits attributable to computer servers as well as some of

the initial policy views on this development. The chapter then reviews the

difficulties that tax authorities encounter when they strive to audit out-of-

state individuals and firms that do not maintain any physical presence

within Canada: the discussion references developments surrounding Euro-

pean Union VATs, the Canadian GST, and offshore credit card accounts.

Most of the matters under scrutiny within this chapter have not yet

attracted judicial attention. As such, the analysis is meant to highlight the

relevant policy issues that tax advocates could integrate within their argu-

ments to assist with protecting client interests. The chapter concludes by

noting that the CRA should increase information exchanges with foreign tax

authorities in order to effectively audit “information arbitrage” strategies by

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taxpayers that take advantage of recent developments that make it harder to

align economic income with financial income which is subject to taxation.

B. SOFTWARE TAX SHELTER LITIGATION

An interesting example of an emerging tax litigation concern surrounds

the use of cross-border software tax shelters, which place a few new inter-

esting twists on traditional shelter activity. This section reviews a recent Tax

Court and Federal Court of Appeal decision where the CRA challenged the

valuation of intangible assets within a software tax shelter.1

1) The Brown Case

The story begins when Peter Brown, CEO of a Toronto stock brokerage

firm, is approached by one of his clients with an investment opportunity.

The client — described as the “godfather” of software joint ventures — told

Mr. Brown of a potential investment in a Canadian partnership (registered

as a tax shelter under the Income Tax Act) that planned to purchase video

game engines from American Softworks Corporation (ASC), a U.S.-based

company. Mr. Brown jumped at the deal and purchased 80 units in the

partnership for $800,000: $140,000 of the purchase price consisted of

equity and the remainder consisted of a promissory note. The partnership

and ASC were non-arm’s length parties that carried on the business of sell-

ing computer games in a joint venture.

In 1993 and 1994, ASC was unprofitable — partly due to large capital

cost allowances that amortized the total value of the computer engines

within these two years — and Mr. Brown deducted his share of the losses

(which amounted to roughly $1 million) from his other sources of income.

In 1995, the company became profitable and Mr. Brown included a portion

of the company’s income within his own gross income (and deducted inter-

est charges for amounts paid to finance his investment, which gave him a

net loss of roughly $4,000).

The CRA assessed Mr. Brown and denied his deductions for losses

associated with ASC as well as any interest deductions.

In many ways, the facts of the case resemble the structure of many ‘old

economy’ tax shelters such as the low income housing shelters that were

popular in the 1980s. Under these older models, high income individuals

would buy units in a limited partnership which would in turn purchase low

Tax Litigation in the New Exonomy 549

1 See Brown v. The Queen, 2002 D.T.C. 1094 (additional reasons at 2002 D.T.C. 1385

and 2002 D.T.C. 1925 (T.C.C.), aff’d 2003 D.T.C. 5298 (F.C.A).