"Then came the churches then came the schools Then came the lawyers then came the rules"
- From the song "Telegraph Road" by Dire Straits
On Thursday January 8, the Supreme Court of Canada released its much- anticipated decision in the case of Lipson v. The Queen, the third decision of the nation's highest court interpreting the general anti-avoidance rule contained in the Income Tax Act (ITA). For those keeping score, the government has taken a 2-1 lead in judgments with its 4-31 victory in the Lipson case.
The result in the case is neither surprising nor overly troubling. The Lipsons had lost their earlier appeals to both the Tax Court of Canada and the Federal Court of Appeal and a victory in the Supreme Court was viewed by many as a long shot at best. However, the reasoning adopted by the majority of the Court and, in particular, its contrast to the approach taken by Mr. Justice Binnie writing for the larger minority in the case is troubling in terms of the implications it may have for tax planning in Canada.
The facts in the case are fairly straightforward. The Lipsons wanted to obtain a mortgage to acquire a house. Mr. Lipson owned shares of a private company that had a value at least equal to the intended mortgage. Mrs. Lipson borrowed money on an unsecured basis from a bank and bought some of Mr. Lipson's shares. Mr. Lipson used the proceeds to purchase the house. Mr. and Mrs. Lipson had arranged with the same bank to place a mortgage on the house and Mrs. Lipson used the proceeds from the mortgage to repay the unsecured loan. By virtue of subsection 73(1) of the ITA, the accrued gain on the shares transferred by Mr. Lipson was not realized as this provision allows property to be transferred by a taxpayer to his or her spouse for proceeds equal to the cost of the property unless the taxpayer elects otherwise. If no such election is made, subsection 74.1(1) of the ITA provides that the income or loss from the property transferred is attributed back to the transferor. In computing the income or loss from the shares, the interest payable on the mortgage would be deductible from the dividends received on the shares by virtue of the combined application of the rules in paragraph 20(1)(c) and subsection 20(3) of the ITA. In the years in dispute, Mr. Lipson deducted the interest payable on the mortgage and included the dividends received on the shares by Mrs. Lipson in computing his income on the basis of subsection 74.1(1) of the ITA.
The Minister assessed Mr. Lipson to deny the interest deduction. Both sides agreed that the provisions of the ITA described above entitled Mr. Lipson to claim the deduction. The only issue raised in the appeal was whether the general anti-avoidance rule (GAAR) applied to allow the Minister to deny the deduction. With respect to the three-step GAAR analysis that has been developed in the case law, the taxpayer conceded that the transactions undertaken by him resulted in a tax benefit and were avoidance transactions (in that the transactions were undertaken primarily to obtain the tax benefit). Accordingly, the only decision for the Court to make was whether the transactions undertaken resulted in a misuse of any specific provision of the ITA or an abuse having regard to the provisions of the ITA read as whole. The majority of the Court held that the transactions resulted in a misuse of the attribution rule in subsection 74.1(1) of the ITA and applied the GAAR to disallow Mr. Lipson's claim of the interest deduction, but held that Mrs. Lipson would have been allowed to deduct the interest. The larger minority of the Court held that the transactions did not constitute abusive tax avoidance and would have allowed the appeal. Mr. Justice Rothstein, in a stand-alone dissenting opinion, held that the specific anti-avoidance rule in subsection 74.5(11) applied to the transaction to prevent the attribution of the dividend income and the interest deduction to Mr. Lipson and, therefore, the GAAR did not apply. Because the Minister had not relied on this specific anti-avoidance rule in assessing the appellants, Mr. Justice Rothstein would also have allowed the appeal.
All of the judges who heard the case agreed that the interest payable by Mrs. Lipson was deductible under paragraph 20(1)(c) and that the transactions undertaken by the Lipsons did not result in a misuse of this provision or of subsection 20(3). As a result, the judgments in this case confirm the validity of the type of tax planning at issue in the Supreme Court's Singleton decision, a case in which the application of the GAAR was not at issue. In Singleton, a lawyer withdrew capital from his law firm to acquire a personal residence and then borrowed an equivalent amount from a bank to re-contribute the capital to the firm. The Supreme Court of Canada allowed Mr. Singleton's appeal confirming his entitlement to the interest deduction in respect of his loan.
While the approach taken by the Court as to the deductibility of interest is favourable to taxpayers, the approach taken as to the application of the GAAR is much less so. Lawyers generally like rules and they like the rules to be clear so that their clients, who must live within the rules, know what they can and cannot do with some degree of certainty. In the previous GAAR cases that have come before it, the Supreme Court of Canada has recognized the need for certainty and predictability in the Canadian tax system. Accordingly, in the Canada Trustco case, the Court stated that the first step in determining whether an avoidance transaction is abusive is to find the policy behind the specific provisions of the ITA that were used to produce the tax benefit that is being challenged. In determining this policy, the Court warned that the tax courts cannot search for an overriding policy that is not based on a unified, textual, contextual and purposive interpretation of the specific provisions in issue. In the Supreme Court's view, such a search would run counter to the overall policy of Parliament that tax law be certain, predictable and fair, so that taxpayers can intelligently order their affairs.
The concept of certainty and predictability is echoed throughout Mr. Justice Binnie's judgment for the larger minority in Lipson. He warns that the GAAR is a weapon that, unless contained by the jurisprudence, could have a widespread, serious and unpredictable impact on legitimate tax planning. In his view, the Minister had failed to identify a specific policy shown to be frustrated by the appellant's plan and the acceptance by the Court of the Minister's resort to "vague generalities" or "overriding policy" would only increase the element of uncertainty in tax planning that Canada Trustco sought to avoid.
It is questionable whether the majority of the Court really does identify the specific policy behind subsection 74.1(1) that is frustrated by the transactions undertaken by the Lipsons. The majority states that the purpose of subsection 74.1(1) is to prevent spouses from reducing tax by taking advantage of their non-arm's length relationship when transferring property between themselves, but it is not clear that the purpose of the subsection is as broad as that. It seems subsection 74.1(1) is a mechanical rule that attributes back to the transferor of property the income or loss from the property transferred. The subsection applies irrespective of whether tax would be increased or decreased as a result of the transfer. As Mr. Justice Binnie noted, the outcome of the transactions was not so much an abuse of the specific provisions as it was a fulfillment of them.
It is this contrast in the process of applying the GAAR between the majority and the larger minority that is most troubling. Mr. Justice Binnie follows the Supreme Court's prior approach previously articulated in Canada Trustco in determining whether there has been abusive tax avoidance. He searches for the specific policy that has been frustrated or defeated and finds none. According to the prior decisions of the Court, it is this approach that ensures certainty and predictability. While the majority does refer to maintaining certainty for taxpayers as an element of the GAAR, the majority expressly recognizes that to the extent that it may not always be obvious whether the purpose of a provision is frustrated by an avoidance transaction, the GAAR may introduce a degree of uncertainty into tax planning. The majority notes that such uncertainty is inherent in all situations in which the law must be applied to unique facts and that a desire to avoid uncertainty cannot justify ignoring a provision of the ITA that is clearly intended to apply to transactions that would otherwise be valid on their face. These comments suggest a possible significant change in the Court's approach to the GAAR. For Canadian taxpayers, it would seem, all that is certain is more uncertainty.