Today, Canada’s highest court denied leave to appeal in Mackay, a case in which the Federal Court of Appeal held that the general anti-avoidance rule (“GAAR”) under the Income Tax Act (Canada) applied to a structured acquisition that resulted in the transfer of losses between arm’s length parties. As a result, the Federal Court of Appeal’s decision in Mackay is now final, leaving last week’s split decision by the Supreme Court of Canada against the taxpayer in Lipson as the most recent pronouncement on GAAR by the court.
Court Rules that GAAR Applies in Lipson
Lipson involved a scheme that was intended to allow the taxpayer to deduct interest on his home mortgage – which is not allowed in Canada. First, the taxpayer and his spouse entered into an agreement to purchase a home. The taxpayer’s spouse then borrowed funds from a bank and used the funds to acquire shares of a family corporation from the taxpayer. The taxpayer used the proceeds from the sale to fund part of the purchase price of the home. The taxpayer and his spouse obtained a mortgage, using the home as security, and then used the proceeds to repay the initial borrowing by the taxpayer’s spouse. The taxpayer relied on four principal rules: (i) interest is deductible on borrowed money used to acquire shares, (ii) borrowed money used to repay a prior borrowing is deemed to have been used for the purpose of the original borrowing (i.e., to acquire the shares), (iii) absent an election, transfers of property to a spouse are generally not taxable, and (iv) under Canada’s attribution rules, income or losses realized by the taxpayer’s spouse are attributed to the taxpayer (in this case, losses arose in taxation years where interest expenses on the borrowed money exceeded the dividends received on the shares).
In ruling that GAAR applied, the majority (LeBel, Fish, Abella and Charron JJ.) looked at the overall result of the transactions and found that the use of the attribution rules to enable the taxpayer to claim the net losses frustrated the object and spirit of those rules. While the majority agreed that it was acceptable to trace borrowed money to an income earning purpose to effectively allow mortgage interest to be deductible (similar to the court’s prior non-GAAR related decision in Singleton), they applied GAAR on the basis that there was a misuse or abuse of the attribution rules (in essence, on the basis that those rules were intended to attribute income (rather than losses) to the spouse with the higher income). In determining the tax consequences to the taxpayer, instead of attributing the net losses and income back to the taxpayer’s spouse, the majority considered it reasonable in the circumstances to attribute the interest expenses back to the taxpayer’s spouse while maintaining the attribution of dividend income from the shares to the taxpayer. The minority (Binnie, Deschamps and Rothstein JJ.), on the other hand, would not have applied GAAR. Binnie and Deschamps JJ. were of the view that the Crown had failed to identify a specific policy shown to be frustrated by the transactions. Finally, Rothstein J. was of the view that GAAR is a provision of last resort, and should not have applied since a specific anti-avoidance rule was applicable.
Court Denies Leave to Appeal in Mackay
In Mackay, the Supreme Court of Canada (LeBel, Deschamps, and Charron JJ.) denied the taxpayers’ request for leave to appeal. Mackay involved a scheme that would have transferred losses to arm’s length persons – which is generally not permitted. A group of taxpayers wanted to acquire a shopping mall from a bank that was in the process of acquiring the mall through foreclosure on a mortgage receivable. The transaction was structured so that the bank would first transfer the mortgage receivable to a partnership ultimately owned by the taxpayers, allowing the partnership to then foreclose on the property. The partnership claimed a loss as a result of the transaction that was allocated to the taxpayers as members of the partnership. The Federal Court of Appeal in Mackay held that GAAR applied for reasons similar to those in Kaulius (also referred to as Mathew). In that case, the Supreme Court held that GAAR applied on the basis that the taxpayers misused or abused a particular provision that was designed to prevent loss transfers to effect a transfer of losses to third parties. (For more details on the Supreme Court’s decision in Kaulius, see the Osler Update of October 27, 2005).
While the loss in Lipson and the denial of leave to appeal in Mackay are significant to the taxpayers in question, the particular facts involved in both cases suggest that their negative implications, if any, may be limited. For example, though divided in Lipson on the ultimate application of GAAR in respect of the related party attribution rules under the Income Tax Act (Canada), the judges were unanimous in their finding that the taxpayer’s spouse would otherwise be entitled to deduct interest against funds borrowed to acquire the family corporation shares, notwithstanding that the funds were refinanced through a mortgage on the family residence (reaffirming its earlier decision in Singleton). This finding may provide some helpful guidance to taxpayers in implementing refinancing or recapitalization transactions. Furthermore, the Supreme Court also noted in Lipson that in determining abusive tax avoidance, the focus is on whether a transaction or series of transactions frustrates the object, spirit or purpose of the particular provisions giving rise to the tax benefit and not to some overall purpose or scheme of the Income Tax Act (Canada). As for Mackay, it would have been difficult for the Supreme Court to hear the case and rule any differently from the Federal Court of Appeal in light of the Supreme Court’s finding against the taxpayers in Kaulius where the facts were substantively the same.
The decision in Lipson, along with Kaulius, does give the Crown its second win at the Supreme Court. The only other GAAR decision of the Supreme Court of Canada is Canada Trustco (represented by Osler). In that 2005 decision, a unanimous nine-panel member of the Supreme Court held that GAAR did not apply to a sale-leaseback arrangement on the basis that it did not constitute abusive tax avoidance. (For more details on Canada Trustco, see the Osler Update of October 27, 2005).