Golombek: What Lipson means for investors
In a split 4-3 decision, the Supreme Court of Canada found that a Toronto couple, the Lipsons, engaged in abusive tax planning that offended the General Anti-Avoidance Rule (GAAR).
The Lipson case, heard at the Supreme Court last April, actually 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 were used to replace the original investment loan.
While the Income Tax Act allows Canadians to deduct interest expense on loans when the funds are borrowed for the purpose of earning income, the twist in this case was that the interest expense attributed back to Earl under the attribution rules.
"Misuse" of the attribution rules
Under the Act, if you sell or transfer shares to your spouse or partner, 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, would 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.
It was this so-called misuse of the attribution rules that was the fatal step which invoked the GAAR. The GAAR allows the Canada Revenue Agency to attack an otherwise legitimate tax plan for being a misuse or abuse of the tax rules as a whole.
In denying the Lipson appeal, what the majority focused on was how the Lipsons handled the transfer of shares.
According to the Court, "the series of transactions did not become problematic until (Earl) and his wife turned to (the spousal attribution rules) in order to obtain the result contemplated ...which resulted in (Earl) applying his wife's interest deduction to his own income."
In other words, it was the use of the attribution rule itself that permitted Earl to effectively deduct his wife's interest expense, something he would not have been able to do if Earl and Jordanna were not husband and wife.
The majority commented that the purpose of the attribution rule is to prevent spouses from reducing tax by taking advantage of their non-arm's length relationship when transferring property between them.
As the Court mused, "It seems strange that the operation of (the attribution rules) can result in the reduction of the total amount of tax payable by Mr. Lipson on the income from the transferred property."
Before the shares were transferred from Earl to Jordanna, any dividends on the shares were taxable in Earl's hands and he could not deduct any interest expense.
After the sale of the shares, however, income on the dividends was still taxable back to Earl yet, the use of the attribution rules to the couple's advantage allowed the interest expense to be claimed by Earl as well.
This, the Court concluded, "qualifies as abusive tax avoidance" since the purpose of the attribution rules was frustrated.
Reached shortly after the decision, Ed Kroft, the lawyer from McCarthy's in Vancouver who represented the Lipsons before the Supreme Court was "disappointed for the Lipsons since this dispute has gone on so long." He called the decision "very important for taxpayers and tax planners because it defines the scope of acceptable tax planning. The split in the court shows an absence of consensus and how opinions differ on the scope of the GAAR."
Impact on the "Singleton Shuffle"
While the Lipson plan itself may be dead, the bigger question is whether the decision will have any impact on a plain-vanilla debt-swap strategy, often known as the "Singleton Shuffle."
The Lipsons essentially 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.
This technique has been employed by many Canadians who own non-registered investments and are 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.
Based on the Lipson ruling, it appears that this strategy is still valid and would not invoke the GAAR. As the majority wrote, the CRA "has not established that in view of their purpose (the interest deductibility) provisions have been misused and abused. Mrs. Lipson financed the purchase of income-producing property with debt, whereas Mr. Lipson financed the purchase of the residence with equity. To this point, the transactions were unimpeachable. They became problematic when the parties took further steps in their series of transactions."
This was echoed by Mr. Justice Rothstein in his minority dissent, saying: "There is no reason why taxpayers may not arrange their affairs so as to finance personal assets out of equity and income earning assets out of debt."
Bottom line? Plain-vanilla debt-swap refinancing seems to be alive and well in Canada.