A loophole in legal limbo

National Post

2006-09-16


Want to borrow $1-billion? Simply walk into your local bank branch and
perhaps they'll offer you the same loan terms they extended to David Grant as
part of a complex plan known in tax circles as a "departure trade."

The veil was lifted on this tax scheme when the practice landed in tax court
this past summer. The test case is just one of several departure trade cases
winding their way to court.

The general principle behind a departure trade is to create an interest
deduction that reduces the tax of an individual who is planning to emigrate from
Canada. Under such a plan, the departing taxpayer borrows money from a financial
institution and incurs interest, which is partially tax deductible for the
period of time prior to the taxpayer's departure from Canada.

The borrowed money is simultaneously reinvested with the financial
institution and the taxpayer earns interest that is not taxable in Canada
because it is received after the taxpayer has ceased being a Canadian resident.

On Christmas Eve, 1998, Mr. Grant and his wife, Catherine, borrowed
approximately US$1-billion from the bank and simultaneously deposited the same
amount with the bank's subsidiary -- the deposit serving as collateral to secure
the loan. While interest payable on the debt was partly due on Dec. 31, and
partly on Jan. 4, the interest on the deposit was payable to the Grants on Jan.
4, 1999, the date both the debt and the deposit matured. However, the Grants
ceased to be residents on Dec. 30, 1998, when they moved to Singapore.

During these six days in 1998, they incurred about US$1.7-million of interest
expense that they attempted to write off of their taxable income for the year.
The Canada Revenue Agency reassessed and disallowed the deduction.

Note that the interest income received on the deposit, which was received in
January, 1999, was not reported at all in Canada since the Grants ceased to
become residents on Dec. 30, 1998.

The CRA posed three arguments for disallowing the interest write-off: First,
the interest was paid on Dec. 31, 1998, after the Grants were no longer
residents of Canada.

Secondly, the interest expense "was used to earn income that was exempt from
tax" -- in other words, to earn income that was not taxable since it was earned
during the period when the Grants ceased to be residents of Canada. (Generally,
in order to deduct interest, the interest must be incurred for the purpose of
earning taxable income.)

Finally, the CRA argued that the interest expense deduction should be
disallowed under the general anti-avoidance rule (commonly known as the GAAR),
since the transaction was an avoidance transaction that constituted an abuse of
the Income Tax Act.

The judge went no further than the CRA's first argument, concluding that
since the interest paid on Dec. 31 generates a loss in the non-resident period
of the year, the loss was not deductible on the Grants' 1998 tax returns. The
Grants have appealed this decision.

Stay tuned for further departure-trade cases.

GRAPHIC: Black & White
Photo: Scott Barbour, Getty Images; Several cases involving a loophole that
allows emigrants to dodge taxes in Canada are winding their way through tax
court.