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WALK THE LINE – LIPSON v. THE QUEEN*

David Louis, B. Com., J.D., C.A., tax partner Minden Gross LLP, member of MERITAS Law Firms Worldwide. 

(*This release is based on an article published in Tax Topics #1782, May 2006, CCH Canadian Limited)

A tax practitioner should not only be able to leap tall buildings in a single bound, he or she should be able to predict the future.  The future many practitioners predicted from the Canada Trustco[1] and Kaulius[2] Supreme Court GAAR cases was the Balkanization of the lower tax courts in the wake of the Herculean tasks imposed by these cases.[3]  But the big question is whether, besides the aforementioned talents, tax practitioners will be able to walk the line - between the seemingly contradictory decisions.

The latest case in point is Lipson v. The Queen[4], which seems to be at odds with Overs[5], another Tax Court GAAR verdict handed down just weeks ago, thus adding to the growing list of seemingly conflicting tax court decisions.  Specifically, Lipson puts a chill into what many tax and financial planners had regarded as tried and true methods for making mortgage interest deductible.  While the strategies may meet the technical requirements for interest deductibility[6], the Lipson case indicates that GAAR will now be the key issue in these manoeuvers.

Lipson itself involved a share swap between spouses - in an attempt to kosher-up what would otherwise have been non-deductible mortgage interest - as follows: 

1.                  The Lipsons entered into an agreement to purchase a residence in Toronto’s tony Forest Hill.

2.                  Mrs. Lipson obtained a demand loan and purchased shares of a family company from her husband.

3.                  Mr. Lipson used the funds to buy the home.

4.                  Mr. and Mrs. Lipson took out permanent financing secured by a mortgage on the new home, and used the proceeds to repay the demand loan.

The results of this transaction will be quite familiar to tax and financial planners:  As the original loan was taken out to buy shares of the family company, the interest would be claimed as a deduction, under paragraph 20(1)(c) of the Act.  Similarly, since the refinancing was used to retire the loan, the interest thereon would, likewise, be claimed as a deduction pursuant to subsection 20(3), which extends the purpose of the original loan to the refinancing.  Because the shares of the family company were transferred on a rollover basis, i.e., pursuant to subsection 73(1), the “attribution rules” (specifically, subsection 74.1(1)) would apply to dividends received on the shares, and the now-associated interest deductions.  Accordingly, Mr. Lipson would declare both on his tax return, rather than Mrs. Lipson.

Man in Black

The case came before the venerable Judge Bowman, Chief Justice of the Tax Court of Canada.  The original reassessments were based on the now-famous Singleton[7] decision – before it was reversed in favour of the taxpayers by the upper courts.  When this became apparent, the CRA shifted its attack to GAAR.  (Interestingly, Singleton was originally heard by the same Bowman, J., who had disallowed the interest expense and was overturned on appeal.) 

In an earlier case following the landmark Canada Trustco and Kaulius Supreme Court decisions (Evans[8]), Bowman, J. had held in favour of taxpayers on a rather elaborate plan to remove surplus from a corporation on an effectively tax-free basis.  But the Lipson case does not share this happy outcome. 

In Lipson, the taxpayer conceded that there was a tax benefit and an avoidance transaction, so that the only issue before the court was whether the transactions constituted abusive tax avoidance.  Bowman, J. cited the Canada Trustco decision as authority that abusive tax avoidance will occur when a transaction defeats the underlying rationale of provisions that are to be relied on and may also result from an arrangement that circumvents the application of provisions, such as specific anti-avoidance rules, in a manner that frustrates or defeats the object, spirit or purpose of these provisions.[9] 

Bowman, J. held that, with respect to the provisions I mentioned earlier, the arrangement did just that.  Specifically, he observed that paragraph 20(1)(c) is intended to permit interest on money borrowed for commercial purposes to be deducted.  The corollary is that interest on money borrowed for personal use is not deductible.  That purpose was frustrated by this arrangement.[10]  Similarly, subsection 20(3), pertaining to refinancing, was abused by attempting to attach to the mortgage refinancing the tax incidents of the original “fleeting use” of the proceeds of the demand loan.[11]  To the extent that subsection 73(1) and section 74.1 were used to achieve these misuses and to execute the scheme as a whole, they too were being misused.  In short, “the overall purpose as well as the use to which each individual provision was put was to make interest on money used to buy a personal residence deductible” [12].

Drawing the Line

I think that the situation in Lipson was, analytically, very similar to Overs, in which Little, J. held that GAAR did not apply[13].  And as mentioned earlier, Bowman, J. himself had recently held that GAAR did not apply in Evans, a case involving the utilization of the capital gains exemption to strip money out of a closely-held corporation.  So how does Lipson reconcile with such cases?  Bowman, J. observed: 

Each case in which the GAAR is applied depends on its own facts and the Supreme Court of Canada has recognized the important factual component that must be considered by the Tax Court of Canada. In both Evans and Overs. . . there was, factually, an underpinning of commerciality or estate planning (although I did not find the estate planning in Evans to be a predominant consideration).  The same distinction can be found between Canada Trustco and Kaulius.  The scheme involved here has no such redeeming features.  Drawing the line between abusive and acceptable tax avoidance requires the exercise of judgement.  It is not a purely mechanical process, nor is it either a discretionary or subjective determination.  .

In determining whether a transaction or series of transactions constitutes abusive tax avoidance, a number of factors may have to be considered and assigned their appropriate weight in the circumstances.  These include the purpose of the statutory provisions relied on, the overall result that the use of the combination of provisions seeks to achieve and the genuineness or artificiality inherent in the transaction.[14]

 

The importance of “an underpinning of commerciality or estate planning” is apparent, as is the great difficulty of achieving certainty in this area.

Finally, I should mention that Bowman, J. indicated that the Supreme Court directive in respect of a unified textual, contextual and purposive analysis “is a general principle of statutory interpretation of broad application and I can think of no reason for not applying it to section 245 as well as any other section of the ITA”[15], thus setting the stage for an expansive interpretation of GAAR itself. (Thus, later in the case, he rationalized: “If there was ever a case at which section 245 was aimed, it is this one”. [16])

Ring of Fire

The difficulty of “drawing the line” is obvious.  Besides Lipson/Overs, tax practitioners have also observed that it is difficult to distinguish Evans, in which a dividend strip was found to be GAAR-free, and Desmarais[17], in which the object and spirit of section 84.1 was held to be frustrated.  (The apparent conflict between recent tax court decisions is not limited to GAAR.  Maege[18] and Baxter[19] go in two very different directions as to the tax shelter definition.[20]) 

Specifically, Lipson means that tax and financial planners must reconsider strategies designed to transmogrify would-be non-deductible interest charges, including everything from “partnership capital roll-arounds” (as in Singleton), to sophisticated financing structures. 

As to farther reaching aspects of the case, personally, I find the statements above distinguishing Evans and Overs to be most interesting.  In fact, trying to reconcile the recent Tax Court of Canada cases underscores the difficulty of “drawing the line between abusive and acceptable tax avoidance.”  Would it have made a difference if Lipson had argued that there was a commercial rationale for the transaction, such as protecting the shares from creditor claims against Mr. Lipson – i.e., would the “line be drawn” differently?[21]  How critical was the application of the attribution rules to the outcome?[22]  Were the details of implementation a factor in the adverse outcome?  I have already been subject to a flood of e-mails between learned tax practitioners as to whether there is a meaningful distinction between Lipson and Singleton. 

At the moment, my only comment is that this underscores that “drawing the line” is truly a Herculean task.  But while drawing the line is in the hands of the judiciary, it is tax practitioners who must walk the line.  Are you up to the task?

-The author wishes to thank Daniel Sandler and Brian Nichols, as well as MERITAS colleagues Guy Dubé (BCF, Montreal), William Cooper and Peter Wong (both of Boughton, Vancouver)