Interest Deductibility
A tax case drew a capacity crowd to the Supreme Court of Canada recently to watch the case of a Toronto couple attempting to deduct interest paid on their mortgage. The issue is important to Canadians, who have long envied the ability of their U.S. neighbours to deduct mortgage interest.
The case began in 1994, when 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. The tax rules allowed the shares to automatically roll over from Earl to Jordanna, and no capital gains were realized or reported.
Earl used the $562,500 received from Jordanna to buy the home. A mortgage was then taken out on the home and the proceeds from that mortgage -- a "substituted loan" -- were used to replace the original investment loan.
The Tax Act allows Canadians to deduct interest expenses on loans when the funds are borrowed for the purpose of earning income. The Lipsons used a variation on the classic "Singleton Shuffle," 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 on investment loans tax deductible.
The Singleton Shuffle has been employed by many Canadians. Those with non-registered investments are often advised to liquidate these investments and use the proceeds to pay off their mortgage. The investor would then obtain a loan secured by the newly replenished equity in their home, and use the loan for earning investment income, thus making the interest on the loan fully tax-deductible.
The Canada Revenue Agency, however, has challenged the Lipson variation using an overarching rule called the General Anti-Avoidance Rule (GARR). The rule allows the CRA to attack a legitimate tax plan for being a misuse or abuse of the rules.
"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," argued the Lipson's lawyer, Ed Kroft, one of Canada's top tax litigators from the Vancouver office of McCarthy Tetrault LLP.
Indeed, while the interest deductibility matter is technically permitted under the refinancing provision of the Tax Act, the CRA seems to be instead focusing on how the Lipsons handled the transfer of shares.
Under the tax rules, if you sell or transfer shares to your spouse, the transfer automatically occurs at your tax cost, meaning no capital gains tax is payable at the time of transfer.
A consequence of this, however, is that under the "attribution rules," any future income, gain or loss on the shares, now legally owned by Jordanna, will attribute back to Earl, which is exactly what happened. Earl claimed and deducted a loss on the shares, computed as the dividends Jordanna received, less the interest expense on the substituted loan.
According to the CRA's arguments, the Lipsons' use of the attribution rules are "the linchpin to the whole system," since they were used "to avoid tax rather than prevent tax avoidance."
In other words, it's the use of these attribution rules that offended the CRA, since the tax department admitted in court that Singleton-type planning alone should not be subject to the anti-avoidance rules. But the truth is, the Lipsons followed the rules as laid out in the Act, which specifically contemplates that the loss on the shares attributes back to Earl.
The Supreme Court will determine if the Lipson variation is an abuse of the Tax Act or legitimate tax planning. A decision is expected by the fall.