In a recent decision of the Ontario Superior Court, Lemberg v. Perris,1 Eric and Valerie Lemberg successfully sued their loyal accountant, Michael Perris (“Perris”), for breach of fiduciary duty. Over the course of their almost twenty-year relationship, Perris provided tax and accounting advice to the Lembergs and performed their tax compliance work.
Perris advised the Lembergs to engage in a so-called “art-flip” tax reduction scheme. The Lembergs accepted Perris’ advice and enjoyed their large tax savings. However, they were reassessed by the Canada Revenue Agency (“CRA”) to disallow all of the benefits they received. Subsequently, the Lembergs learned that Perris had received a “secret commission” from the scheme’s promoters to help sell the art-flip deal.
In finding in favour of the Lembergs, the Court held that Perris was in a fiduciary relationship with them and that he had breached his fiduciary duties. The most fundamental breach was Perris’ acceptance of the secret commissions, which meant that Perris was working not for the Lembergs, but rather for the promoters of the art-flip scheme. The Court found that Perris had induced the Lembergs into investing in the scheme and that he had abused his relationship of trust and confidence which had been established over many years. The Court held that Perris was acting in his own best interest, not in the best interest of the Lembergs, when he advised them on the art-flip scheme. Consequently, the Court ordered Perris to compensate the Lembergs for the difference between the amount they had paid for the artwork and their tax savings realized, for a total of $39,797. The Court also ordered that Perris disgorge the $7,500 secret commission he had received from the promoters of the scheme.
Art-flip schemes are straightforward. Taxpayers buy limited edition prints in bulk from the scheme’s promoters at a significant discount. These prints are then donated to United States-based educational institutions or other charities. The taxpayer receives a tax receipt based on an appraised market-value of the prints, which is invariably several times higher than the actual price paid for the artwork, resulting in large tax savings. For example, in the Lemberg’s case, their $31,000 paid for their 1998 participation in the scheme yielded a donation receipt of $136,500.
The CRA re-assessed the Lembergs on the basis that the tax benefit must be based on the actual purchase price of the artwork, not the higher appraised value. The CRA’s reassessments against the huge numbers of taxpayers involved in art-flip schemes spawned waves of litigation, and in 2004 the test case of Klotz v. Canada2 was heard by the Tax Court of Canada (“TCC”). The TCC held that any tax benefit must be limited to the actual purchase price of the art, rather than the purported appraised value when the art was donated.
The art-flip scheme used by the Lembergs was supported by tax opinions from certain Canadian law firms. These legal opinions confirmed that it was possible for buyers to obtain tax credits based not on the purchase price paid, but on the higher appraised value of the art. However, the opinions were based on the assumptions that a buyer would purchase several prints over an extended time, receive actual possession of the art, gift some of the art to friends and family, retain some of it for personal use, and periodically donate prints to a number of different charities. The legal opinions also assumed that buyers would play a hands-on role in selecting the recipients of the donated artwork. Purchasing and donating the art strictly to obtain a tax benefit would vitiate the required “donative intent”, and undermine the validity of the tax planning.
However, as is invariably the case, in practice the facts differed materially from the facts assumed in the tax opinions. The participants in an art-flip scheme, such as the Lembergs, typically had little or no knowledge of the recipients of the artwork and never took possession of the art, nor played any role whatsoever in selecting the recipient. In fact, the Lembergs had never seen the art they purchased and had never heard of the universities that received their “charitable donations”. Rather, the majority of taxpayers purchased the artwork for the sole purpose of obtaining a charitable tax deduction. The Court in Lemberg was critical not only of the accountants who recommended these schemes, but also of the lawyers who provided the legal opinions that “lent apparent legitimacy to the scheme”.3 In particular, the Court noted that because Perris’ loyalties were divided, he did not pay sufficient attention to the risks associated with the art-flip scheme, notwithstanding that the actual execution of the transactions by the Lembergs and others “bore little resemblance to the circumstances of the actual transactions that were recommended” in the tax opinions.
Like the Court in Lemberg, in Klotz the TCC was critical of the legal opinions that were used to promote the tax avoidance scheme to investors, stating “[s]uch opinions are stated to be subject to so many qualifications, provisos and assumptions that it is difficult to see how a client could derive much comfort from them”.4 These opinions were used enthusiastically by promoters to support these schemes. However, they were based on ideal facts and assumptions, which differed materially from the actual facts in how many of these transactions were later implemented.
The majority of taxpayers, including the Lembergs, did not read the opinions or seek independent legal advice to evaluate their utility. If they had, they would have likely detected glaring discrepancies between the assumptions upon which the opinions were based and reality. In Klotz, the TCC made the following critical comment: “[h]e had two legal opinions which, however qualified they might be, would be taken by the average layman as implicitly putting the imprimatur of two major law firms on the program.”5
This case raises important issues for taxpayers who participate in these and other charitable tax avoidance schemes, and their advisors. Clearly, Lemberg confirms that a financial and tax advisor with a long-standing client relationship has a fiduciary duty to that client. Therefore, the adviser has an obligation to put the client’s interests first. Consequently, when it comes to aggressive, if not dubious, tax planning, an advisor should be watchful and prudent in safeguarding the client’s interest.
Further questions raised by this case and other pending related cases include whether tax advisors should be:
- more circumspect in providing opinions on potentially aggressive tax planning products;
- wary of the prospect of litigation when advising on potentially aggressive tax planning products that are highly likely to lead to reassessments against participants;
- alert to the use or misuse of tax opinions which are provided to a wide, unsophisticated group of potential “investors” as opposed to knowledgeable business persons;
- concerned about ethics and professional responsibility when participating in the structuring of potentially aggressive tax planning products; and
- concerned about reputational damage arising from providing advice on potentially aggressive tax planning products.
The Lemberg case certainly rings many warning bells for both taxpayers and their advisors.