Supreme Court hears interest deductibility case

Advisor's Edge

2008-04-23


(April 2008) Wednesday morning, in a jam-packed Supreme Court of Canada, the country's highest court heard arguments in the now-infamous Lipson tax case, involving interest deductibility and the General Anti-Avoidance Rule (GAAR).

So great was the interest in the case that a line snaked its way outside of the courthouse onto the front steps as anxious observers waited with patient anticipation to pass through the security checkpoint just inside the building and to secure a coveted seat inside the courtroom.

Also in attendance were Earl and Jordanna Lipson, accompanied by their two children, who came to watch their lawyer, Ed Kroft, a tax litigator from the Vancouver office of McCarthy Tétrault LLP argue their case.

No doubt advisors are now well-familiar with this case, which began in 1994, when the Lipsons, a Toronto couple, used a variation of the "Singleton Shuffle" to make what would otherwise have been non-deductible interest, tax deductible.

The Singleton Shuffle was named after Vancouver lawyer John Singleton's 2001 Supreme Court victory, which upheld the notion that you can rearrange your financial affairs in a tax-efficient manner so as to make your interest tax deductible if the funds are borrowed for the purpose of earning income.

Since that 2001 decision, advisors have encouraged Canadians who have non-registered investments to liquidate these investments and use the proceeds to pay off their mortgage. Investors could then obtain a loan secured by the newly-replenished equity in their home, and use the loan for the purpose of earning investment income, thus making the interest on the loan fully tax-deductible.

That plan, essentially endorsed by Mr. Singleton's Supreme Court win, was implemented without concern by numerous Canadians - that is until a variation of it was attacked by the Canada Revenue Agency in the Lipson case, using the GAAR.

The GAAR is an overarching rule in the Tax Act that can attack a legitimate tax plan for being a "misuse or abuse" of the rules. The GAAR was never argued by the CRA in the original Singleton case and thus the Court did not have a chance to comment as to whether it should be applied to such a strategy.

In 1994, Earl and Jordanna Lipson wanted to buy a home. Jordanna borrowed $562,500 from the bank and used the money to purchase $562,500 worth of shares in the family's corporation from her husband at fair market value.

Because Mr. Lipson did not elect out of the automatic rollover, the shares were sold from Earl to his wife for proceeds equal to their adjusted cost base (ACB) and thus no capital gain needed to be reported. Consequently, the attribution rules would apply to attribute any future gain on the sale, as well as any future income or loss from the transferred shares from Earl back to Jordanna.

Earl used the $562,500 received from Jordanna to buy the home. The home was subsequently mortgaged and the proceeds from that mortgage (the "substituted loan") were used to replace the original investment loan.

The question before the court was not only whether the interest expense on the substituted loan was deductible but also whether, by operation of the attribution rules, the "loss" on the shares (computed as dividends Jordanna received, less the interest expense on the substituted loan) was deductible to Earl.

To date, the Lipsons have lost in both the Tax Court of Canada in April 2006, and again in the Federal Court of Appeal last year.

What is most intriguing about the Crown's argument before the Supreme Court was the acknowledgment that, in its opinion, Singleton-type planning would still be possible today and should not be subject to the GAAR.

This is because Mr. Singleton had the cash sitting in the capital account of his law firm and thus was free to use that cash for a non-income producing purpose (buying a home) and to borrow money for an income-producing purpose (to refinance the capital account of his law firm) and thus deduct the interest.

By contrast, the Crown argued that Mr. Lipson had no pre-existing equity in his home before the original borrowing by Mrs. Lipson. He had equity in his shares, but wasn't prepared to realize on it beyond selling it to his wife. Since the money was maintained in the same family unit, Mr. Lipson had "no tax-paid money available to him" and thus "had no choice to make," unlike Mr. Singleton who had cash in his partnership capital account.

The Crown also focused on the use of the attribution rules, calling their use "the lynchpin to the whole system" since they were used "to avoid tax rather than prevent tax avoidance."

That may very well be the factor the Court focuses on during its deliberations that might distinguish the Lipsons' planning from a plain-vanilla Singleton Shuffle.

The Supreme Court, which reserved its judgment, will still need to determine if what the Lipsons did actually constituted an "abuse" of the Tax Act, or rather, legitimate tax planning.

As Mr. Kroft stated, "Everyone is motivated to tax plan. Tax minimization is accepted as a basic tenet of tax law. Abuse should not be determined on a 'smell test' or on an offended sense of morality."

A decision is expected by the fall.