In January 2009, the Supreme Court of Canada released its decision in the Lipson case on the application of the General Anti-Avoidance Rule (GAAR).
The taxpayer, Earl Lipson, owned shares of an investment company (Holdco). His wife, Jordanna, borrowed $562,500 from a bank to acquire some of his Holdco shares at fair market value. As part of the same series of transactions, the Lipsons agreed to purchase a house for $750,000, for which Mr. Lipson used the proceeds from the sale of his Holdco shares. On closing of the house deal, the Lipsons took out a $562,500 mortgage secured by the house. Proceeds of the mortgage were used to pay off Mrs. Lipson’s bank loan for the Holdco share purchase.
The interest on the mortgage loan was deducted from the taxable dividends on the Holdco shares held by Mrs. Lipson by virtue of the operation of a number of provisions in the Income Tax Act (Canada). Paragraph 20(1)(c) and subsection 20(3) allowed Mrs. Lipson to deduct interest expense on money borrowed to acquire or refinance the acquisition of an income-producing asset, i.e., the Holdco shares. Subsection 73(1) permitted Mr. Lipson to transfer his Holdco shares to Mrs. Lipson without immediate tax consequences, such that any future gain or loss resulting from the disposition by Mrs. Lipson of the Holdco shares would be attributed back to Mr. Lipson. Finally, any income or loss from the Holdco shares held by Mrs. Lipson (the taxable dividends less the interest expense) was attributed back to Mr. Lipson under subsection 74.1(1). As a result of these provisions, Mr. Lipson was entitled to deduct the interest on the loan obtained by Mrs. Lipson to purchase the Holdco shares, as refinanced with the mortgage loan.
The Minister disallowed the interest expense claimed by Mr. Lipson on the basis that the GAAR applied and that the series of transactions amounted to abusive tax avoidance. The dividend income remained taxable to Mr. Lipson, and Mrs. Lipson was not permitted to deduct the interest expense.
At the Tax Court, the taxpayer agreed that the transactions were "avoidance transactions" that had resulted in a tax benefit. The Tax Court held that the GAAR applied, on the basis that the "overall purpose" and the use to which the relevant provisions of the Act were put was to make interest on money used to buy a personal residence deductible. Thus, the series of transactions resulted in a misuse of those provisions.
The Federal Court of Appeal dismissed Mr. Lipson’s appeal. It held that, viewed separately, none of the transactions appeared to be abusive, and that the Tax Court was entitled to consider the transactions as a series and to conclude the transactions had resulted in a misuse of the statutory provisions upon which Mr. Lipson relied to obtain tax benefits.
By a majority of 4-3, the Supreme Court held that:
1. The transactions whereby Mr. Lipson sold his shares to his wife (who financed the purchase with debt), and then financed the purchase of the house with the proceeds of that sale, were "unimpeachable," such that interest on the debt was deductible. Thus, debt-structuring to obtain an interest deduction by Mrs. Lipson, which had been in doubt as a result of the Federal Court of Appeal decision, was confirmed as acceptable under the GAAR.
2. The transactions were considered abusive tax avoidance and the GAAR applied. The use of the attribution rules in the Act to permit Mr. Lipson to claim his wife’s interest deduction was contrary to the purpose of subsection 74.1(1) of the Act. This rule was "to prevent spouses from reducing tax by taking advantage of their non-arm’s-length relationship when transferring property between themselves." The majority focused on the words "directly or indirectly" in subsection 245(4) and concluded that "Parliament intended the GAAR to apply even where abuse is an indirect result of a transaction." The majority concluded that regard may be had to a series when determining whether a transaction within the series is abusive.
3. In applying the GAAR to disallow the interest deduction to Mr. Lipson, the majority held that Mrs. Lipson was entitled to deduct the interest expense as being a "reasonable outcome" in the circumstances. Mr. Lipson remained taxable on the dividend income.
McCarthy Tétrault Notes:
Three sets of reasons of the Supreme Court demonstrate that many aspects of the GAAR will be developed in future jurisprudence. These may include the ability to look at the entire series of transactions in determining whether one of the steps in a series results in a misuse or abuse and the interplay between the operation of specific anti-avoidance rules and the GAAR. Of particular significance is that all the judges concurred that the interest expense was deductible and acknowledged the right of taxpayers to plan their affairs to achieve tax-deductible interest expense for their income-producing assets and business operations. This conclusion is consistent with earlier decisions of the Supreme Court, including cases decided prior to the introduction of the GAAR. There was common ground among the judges on many points. However, they did not agree on all aspects of the application of the GAAR, such as the satisfaction of the Minister’s onus to provide abusive tax avoidance.
For a more detailed discussion of this case, please see the longer article on our website.
McCarthy Tétrault acted for the taxpayers in Lipson.