On January 8, 2009, the Supreme Court of Canada dismissed the taxpayer’s appeal in Lipson v. The Queen (“Lipson”). The Lipson case analyzes what constitutes abusive tax avoidance for the General Anti- Avoidance Rule (“GAAR”). The majority, consisting of four judges of the Supreme Court of Canada, held that the interest deduction resulting from the refinancing of the shares of a family corporation by the wife of the taxpayer was not abusive viewed in isolation, but that the ensuing tax benefit arising by virtue of the attribution of the interest deduction of the wife of the taxpayer to the taxpayer himself was an abuse and misuse of the provisions of the Income Tax Act (Canada) (“Act”). Three judges strongly dissented from the majority decision.
The decision of the majority of the Supreme Court of Canada has the potential to significantly broaden the scope of the GAAR and create uncertainty for tax planning. Existing tax plans should be re-examined in light of the Lipson decision. Taxpayers will also need to consider this decision in future tax planning.
Highlights of the Lipson Decision
The following are highlights of the decision:
- Three judges strongly dissented from the majority decision thus creating uncertainty as to the scope of application of the GAAR;
- In his dissenting decision, Justice Binnie expressed concern that the majority decision in Lipson would overly curtail the wellestablished principle that taxpayers are entitled to arrange their affairs to minimize the amount of tax payable;
- There is a lack of consistency in identifying the proper threshold for the application of the misuse and abuse test. Prior to Canada Trustco the misuse and abuse test required the Minister to identify a clear and ambiguous policy that had been offended. In Canada Trustco, the Court held that the Minister must identify a clear policy that had been offended. In Lipson, the Court stated that the Minister must prove on a balance of probabilities that the avoidance transaction resulted in an abuse or misuse;
- The decision of the Supreme Court of Canada casts doubt on the possibility of being able to exclude the application of the GAAR in a situation where specific anti-avoidance measures already exist but the complexity of the transactions fall outside the specific rule;
- The decision of the Supreme Court of Canada confirmed that the Singleton decision still constitutes good law even apart from the concession of the Crown.
The taxpayer and his wife had entered into an agreement to purchase a house for $750,000. The day before the closing date, the taxpayer’s wife borrowed $562,500 from a bank. The wife used the borrowed money to buy shares of a family company from the taxpayer. The taxpayer used the cash received from his wife (plus other cash) to purchase the house owned jointly with her.
The next day, the taxpayer and his wife borrowed $562,500 from the bank, secured by way of a mortgage on the new house. These funds were used to pay off the wife’s loan to the bank borrowed the day before.
During the three taxation years in issue, the wife incurred interest expenses on the mortgage loan. She received dividends on the shares of the family corporation in two of the years. She claimed the interest expense associated with the mortgage loan as a deduction, on the basis that the second loan was used to repay money previously borrowed for commercial purposes.
The taxpayer did not elect out of the rollover rules which facilitate inter-spousal transfers of property without immediate tax consequences when he transferred the shares to his wife. As a result, the attribution rules applied and any income or loss from the shares computed in the hands of the wife was deemed to be that of the taxpayer.
The CRA’s Position
The CRA denied the deduction of the mortgage interest on the basis that the GAAR applied to the series of transactions.
Decision of the Tax Court of Canada (2006 TCC 148 - 2006 D.T.C. 2687)
Chief Justice Bowman analyzed the overall purpose of the transactions. He found that these transactions formed part of a series, the purpose of which was to make interest payable on the mortgage given in respect of the purchase of the principal residence deductible by creating the impression that monies were borrowed to buy shares when in reality the monies were borrowed to buy a house.
He concluded that the arrangement resulted in an abuse of the provision of the Income Tax Act (ITA) which permits interest on money borrowed for commercial purposes to be deducted. He found that the purpose of this provision – which is to create an incentive to accumulate capital with the potential to produce income – was frustrated by the arrangement. He also noted that provisions which aimed to facilitate refinancing in the commercial world, to permit inter-spousal transfers of property without immediate tax consequences and, to prevent income splitting were misused by the taxpayer.
Decision of the Federal Court of Appeal (2007 FCA 113 – 2007 D.T.C. 5172)
The Federal Court of Appeal reviewed the decision of Chief Justice Bowman of the Tax Court specifically on the issue of whether in a GAAR misuse analysis the court is entitled to consider the overall purpose of a series of transactions or whether the court’s inquiry in this regard is limited to a consideration of the actual transactions and legal relationships actually created.
The Federal Court of Appeal found that in considering the transactions individually abusive tax avoidance did not occur as none of the ITA provisions had been misused. However, in considering the overall purpose of transactions designed to obtain interest deductibility in connection with a borrowing that indirectly financed the acquisition of a personal residence, the Court concluded that there was sufficient misuse to constitute abusive tax avoidance.
The Federal Court of Appeal said that Chief Justice Bowman was entitled to consider the transactions as a whole and their overall purpose in the conduct of his misuse and abuse analysis. The Federal Court of Appeal expressly said that where a tax benefit results from a series of transactions, the series becomes relevant in ascertaining whether any transaction within the series gives rise to an abuse of the provisions relied upon to achieve the tax benefit.
The Federal Court of Appeal deferred to the Tax Court’s decision and confirmed that there was abusive tax avoidance.
Majority Decision of the Supreme Court of Canada (2009 SCC 1)
For the purposes of applying the misuse or abuse analysis at subsection 245(4) of the Act, the Supreme Court of Canada held that the entire series of transactions must be considered in order to determine whether the individual transactions within the series constitute an abuse of one or more provisions of the Act. However, it tempered its finding by cautioning that the focus of the analysis should not be on the “overall purpose” of the transactions. Such an approach could imply that the taxpayer’s motivation or purpose of the transaction is determinative in the analysis of the test at subsection 245(4) of the Act. Rather, the Supreme Court of Canada held that the transactions should be considered by reference to the overall result.
The majority of the Supreme Court of Canada held that the attribution to the taxpayer of the net income or loss derived from the shares acquired by the taxpayer’s wife enabled the taxpayer to reduce the dividend income attributed to him by the amount of the interest on the loan secured by his wife to acquire the shares. If the dividend income had been received directly by the taxpayer, no interest expense could have been deducted by him. The Supreme Court of Canada held that recourse to the attribution rules qualified as abusive tax avoidance as it frustrated the purpose of the attribution rules. The majority of the Supreme Court recognized that the GAAR may introduce a degree of uncertainty into planning to the extent that it may not be obvious whether the purpose of a provision is frustrated by an avoidance transaction.
As a consequence of the application of the GAAR, the interest deduction in computing the income or loss attributed to the taxpayer was refused and that deduction was attributed back to the taxpayer’s wife.
Dissent of Justices Binnie and Deschamps
In his dissenting opinion, Justice Binnie expressed concern that the long established principle that taxpayers are entitled to arrange their affairs to minimize the amount of tax payable would be overly curtailed by the majority decision. He held that no specific policy was frustrated by the transactions at issue. He specifically took issue with the Minister’s justification that the GAAR should apply on the basis that the taxpayer wanted to sell the shares to his wife in order to trigger the income-earning use, but he didn’t want the consequences that a sale of shares would normally carry with it. According to the decision of Justice Binnie, this outcome is precisely the outcome contemplated by the Act. As such, there is no abuse of the provisions of the Act. Rather, the provisions are fulfilled. By ignoring the initial sale of shares and recharacterizing the interest payment in relation thereto as nothing more than interest on a house mortgage, and effectively arguing for a standalone prohibition on the deductibility of a house mortgage interest (despite Singleton), the Minister was engaging in the sort of vague appeal to “overriding policy” or “overarching policy” that Canada Trustco sought to eliminate from the GAAR analysis.
Justice Binnie specifically stated:
In my opinion the Minister has failed to identify a specific policy shown to be frustrated by the appellant’s plan. The approbation 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.
Application of the GAAR in these circumstances did not promote consistency, predictability and fairness in the tax system.
Dissent of Justice Rothstein
In his dissenting decision, Justice Rothstein held that the GAAR does not apply to the facts as there is a specific anti-avoidance rule that preempts application of the GAAR. For a finding of misuse and abuse in respect of a transaction, all other relevant provisions of the Act must be read before recourse to the GAAR, which is a provision of last resort. The GAAR is a last resort supplementary rule, not a catchall to be deployed on each suspected occasion of abusive tax avoidance.