A recent decision of the Tax Court is at times interesting, surprising and disturbing. The case – Swirsky v R, 2013 TCC 73 – raises an important question about the scope of paragraph 20(1)(c) of the Income Tax Act. That paragraph allows the deduction of interest paid on money borrowed “for the purpose of earning income.” In the case, the taxpayer owned the shares of a family real estate company. He sold some of his shares to his wife for cash equal to the fair value of the shares. She borrowed the money for the purchase from an arm’s length lender. Interest was paid on the borrowed money in the years following the purchase. No dividends were paid for a number of years, so the wife realized losses. The husband then deducted the losses in computing his income on the basis that section 74.1 attributed them to him. The CRA disallowed the deduction on the basis there were no losses to attribute because the borrowing by the wife was not made “for the purpose of earning income.”
In the CRA’s view the wife never expected that dividends would be paid on the shares. It pointed to several factors. She admitted that she purchased the shares on the advice of her husband and his accountant. They devised the plan in an effort to insulate the husband’s shares from claims by creditors. That plan (which the court accepted as the primary reason for the share purchase) did not make any reference to the payment of dividends on the shares purchased by the wife. She testified that she went along with the plan to protect the family’s access to income from the company in the event creditors seized her husband’s shares. The company had no prior history of paying dividends. The family withdrew cash from it from time to time and the company posted the amounts to the husband’s advances account. The account was cleared periodically with bonuses to the husband, not by the payment of dividends.
Although not specifically mentioned in the reasons for judgment, it seems pretty clear that the company was profitable. There were valid concerns about certain large mortgage obligations on which the husband was personally liable along with the company. Although no dividends were paid, the company was able to pay significant bonuses to the husband in the years in question. Several years into the plan, the company did in fact pay dividends on the shares owned by the wife. The CRA added these dividends to the husband’s income, but continued to deny the deductibility of the interest paid on the loan taken out by the wife to buy the shares.
The case is interesting for the CRA’s approach to the purpose test in paragraph 20(1)(c). In neither the Tax Court decision in Overs, 2006 TCC 26, nor in the Supreme Court decision in Lipson, 2009 SCC 1, both of which dealt with somewhat similar facts, did the CRA take the position that the interest was not deductible because of the “purpose to earn income” test, as it did in this case. Also of interest here are the Crown’s alternative arguments based on subsection 74.1(11) and section 245. These were dismissed on the basis that the interest deduction was neither one of the main reasons for the plan (the subsection 74.1(11) argument), nor the primary reason for the plan (the subsection 245(3) one).
I was initially surprised that the Crown did not assess on the basis of the general anti-avoidance rule (section 245). The Supreme Court in Lipson supported the Crown’s GAAR argument on very similar facts. However, on reflection I realize that the assessments in this case were made well before the decisions in the Lipson appeal. The Crown did add the GAAR as an issue at the trial, but was unable to persuade the court (as it had the onus to do in that situation) that the interest deduction was the primary purpose of the plan. The court also held that subsection 74.1(11)) did not apply to deny the attribution of the losses to the husband. On this point the court held that obtaining the interest deduction was not one of the main reasons for the plan. Tax planners will find the court’s reasoning on these points very interesting and the case is worth reading for this quite apart from the s. 20 issue.
That brings me to my last point. I am somewhat disturbed by the way the court decided this case. To me, the result is not appropriate on the facts as reported. What seemed to happen here was that the wife failed the requisite purpose test because she didn’t know what section 20(1)(c) was all about. She was concerned about the family’s continued access to income from the company, but apparently was not knowledgeable enough about the technical requirement of the tax rules to say that she acquired the shares with the specific intention of earning dividends. By holding that she could meet the test only by showing a specific expectation of dividends seems to me to over emphasize her subjective intention at the expense of an objective analysis of the income producing potential of the shares based on the company’s financial resources. It’s pretty clear that the company did not have a policy against paying dividends; dividends were paid in subsequent years. When the subject matter of an investment with borrowed funds is shares in a profitable company, if the company does not have a stated policy against paying dividends the taxpayer should not have to show some specific expectation of dividends at any particular time. That possibility should be an accepted inference from the objective facts. I find it disturbing that the court placed so much emphasis on the wife’s subjective intention at the time she acquired the shares. With the benefit of hindsight, it is easy to see how rather minor changes in the overall plan would have protected the interest deduction as well as the creditor proofing objective, something tax advisors will want to keep in mind when structuring similar inter-family share transfers.