In a split decision rendered in January 2009, the Supreme Court of Canada ("SCC") applied the general anti-avoidance rule under section 245 of the Income Tax Act (Canada) (the "Act") to deny interest deductibility in the highly anticipated Lipson decision.
The Sworded Facts
In the spring of 1994, Mr. and Mrs. Lipson entered into an agreement to purchase a home for $750,000. The closing date in respect of the purchase was September 1, 1994. On the day before closing, Mrs. Lipson borrowed $562,500 from a bank and used the money to purchase certain shares that Mr. Lipson held in a family corporation. The proceeds from the sale of the shares were used towards the purchase of the home by the Lipsons on closing. The next day, the Lipsons mortgaged the home and used the money to repay Mrs. Lipson's original loan in respect of the purchase of shares.
The initial tax consequences were as follows:
- No capital gain - By virtue of the automatic spousal rollover under s. 73(1) (which was not opted out of), there was no capital gain to Mr. Lipson on the sale of the shares to Mrs. Lipson; and
- Attribution of income/loss - Mrs. Lipson's dividend income and her section 20(3) interest expense were attributed to Mr. Lipson under section 74.1.
Relying on the general anti-avoidance rule (the "GAAR") under section 245 of the Act, the Minister disallowed the interest expense claimed by Mr. Lipson in his 1994, 1995, and 1996 tax returns. The parties conceded that the transactions were avoidance transactions for purposes of the GAAR, therefore the sole issue before the court was whether the transactions constituted an abuse or misuse.
Decisions of the Tax Court and Federal Court of Appeal
The Tax Court of Canada disallowed the interest expense on the basis that the GAAR applied. The court held that the "overall purpose" of the transactions was to make interest incurred on a residential mortgage deductible under the Act, and this resulted in a misuse of the relevant provisions of the Act.
The Federal Court of Appeal was of the view that in deciding whether there was a misuse of the Act to obtain a tax benefit, the Tax Court was correct to consider the transactions as a series and the "overall purpose" of the series of transactions. Moreover, the Tax Court was correct in finding a misuse of the Act.
The Supreme Court Decision
The majority decision (4:3) was delivered by Mr. Justice LeBel wherein it was held that each step of a series of transactions impacts other steps. Determining whether there was an abuse or misuse of a provision involves looking at individual benefits separately, but always in the context of the whole series of transactions. LeBel J. noted that the "overall result" of the series is important to such a determination of abuse. Moreover, the Tax Court seems to have used an "overall results" approach and its use of the term "overall purpose" was essentially incorrect. He also confirmed that an economic substance test was not determinative of whether or not there was abuse, but was only relevant to establish whether a transaction frustrated or defeated the purpose of the relevant statutory provisions.
LeBel J. held that re-ordering one's affairs to obtain an interest deduction, as was the case in Singleton v. Canada, 2001 SCC 61 ("Singleton"), does not offend the GAAR. Paragraph 20(1)(c) and subsection 20(3) had not been misused or abused.
The decision of the majority ruled that the transaction became offensive when the attribution rules were used to enable Mr. Lipson to claim Mrs. Lipson's interest deduction. The attribution rule under section 74.1(1) (which was enacted as an anti-avoidance rule) was not intended to be used in this manner, irrespective of the fact that the rule applied automatically. Thus, the dividend was rightly attributed to Mr. Lipson, but the interest expense was not.
In the dissenting opinion of Binnie J, with Deschampes J concurring, it was held that Singleton-type panning was acceptable. However, Binnie J. was of the view that the rollover and attribution rules applied automatically in the case at bar, and the application thereof should not taint the entire series of transactions such that the GAAR applies.
In the other dissenting opinion, Rothstein J. agreed with the majority and the other dissent in that GAAR does not apply where taxpayers restructure their finances in a tax-efficient manner. However, Rothstein J. held that the GAAR was a rule of last resort and it did not apply to the facts at hand because of the applicability of the specific anti-avoidance rule in subsection 74.5(11).
Lessons from Lipson
The first and arguably the most important lesson has to do with Singleton-type planning: While the bench of the Supreme Court of Lipson produced three separate judgments, all of the judges blessed Singleton-type planning. That is, all of the judges agreed that a taxpayer is free to restructure his or her affairs to leverage income-earning assets and fund personal assets through equity without invoking the GAAR.
The second lesson is that in engaging in Singleton-type planning, one ought to avoid using a "shield" as a "sword". Albeit for different reasons, five of the seven sitting judges took issue with the use of the attribution rules by the taxpayers to obtain a tax benefit. The attribution rules generally operate to prevent income-splitting thereby shielding the government from loss of tax revenue. In this case, the government's shield was used as a sword by the taxpayers to obtain a tax benefit, namely an interest deduction.
The tripartite decision of the Supreme Court in Lipson speaks to the uncertainty that surrounds the GAAR and its application; we are left with the unsatisfactory decision of the majority. The outcome of the Lipson case could have been very different if the composition of the seven-member panel was different, or if all nine justices had heard the case. Going forward, the outcome of a GAAR challenge by the CRA to planning beyond Singleton will be dependent upon the presiding judge or judges on any given day.
The lack of clear guidance by the Supreme Court has left taxpayers and their advisors with what is tantamount to a smell test for determining whether a particular tax plan is abusive and, thus, offensive to the GAAR. To this end, taxpayer beware...don't use a shield as a sword!