The Tax Court of Canada has revisited the deductibility of mortgage interest in a July decision in which it disallowed a claim for the deduction of interest on a loan claimed as a business expense.

The interest was not deductible, the court concluded, because the direct use of the borrowed funds was to reduce a debt owing on a principal residence. It did not matter that Vancouver taxpayer Nina Sherle ultimately used the funds to finance another income-producing property that she owned, the court added.

The issue has been an unsettled one for those with both personal residences and business interests, following a handful of decisions from the Supreme Court of Canada over the last decade.

In general terms, the question is whether swapping a business loan for a mortgage on a personal residence, with the purpose of creating deductible interest, is permitted.

In the Lipson case, the most recent review of the issue by the Supreme Court [see Investment Executive, Mid-January 2009], such “mortgage-swaps” were allowed to stand; however, the taxpayer in that case lost on the issue of using the attribution rules to transfer the resulting deduction between spouses.

Lipson was thought to muddy the waters somewhat, given the presence of a strong dissent and comments by the court on the general anti-avoidance rule that many experts found confusing. The new decision from the tax court adds more fuel to the debate.

In this instance, Sherle switched the uses of two properties that she owned, turning a personal residence into an income property and a rental-income property into a personal residence. She then transferred existing debt from the (former) income property to the (former) principal residence. But when she tried to deduct the interest from the newly created mortgage on the new rental property, it was disallowed by the CRA.

The agency alleged that the question was not the purpose of the new financing, but rather the actual, direct use of the loan for which a deduction was sought: in this case, the actual use was to pay off the pre-existing debt on the new principal residence, not to finance the new rental property. It was not relevant, the CRA argued, that the result was to create a new income- producing property for the taxpayer.

Justice Joe Hershfield held for the CRA; but in doing so, he made it clear he was not entirely comfortable with that result and that he did so on the basis of the Supreme Court’s ruling in Lipson.

The Supreme Court’s decision in that case overturned findings by both the tax court and the Federal Court of Appeal that the Lipson’s mortgage swap offended GAAR and was not deductible.

In Sherle, Hershfield referred to both the Lipson and Singleton, decisions: in the latter, 2001 decision, a lawyer successfully switched capital between his practice and his personal residence and was allowed to deduct the interest on what was essentially a loan to buy a home. The swap became known as the “Singleton shuffle.”

In both of those prior cases, the borrowed funds were directly used to finance business interests (with the monies eventually finding their way to mortgages on personal residences).

However, Sherle used the borrowed funds to pay off an existing loan on the new principal residence. It did not matter that her purpose was to create a new, encumbered rental property, and a mortgage-free principal residence.

In so holding, Hershfield noted that, if the “purpose” test was in fact the proper one (as the tax court had held when it heard the Lipson case), Sherle would have had a better chance of success, as at least part of her purpose was to create a new, income-earning property.

But as “purpose” is no longer the measure of whether a loan is a business expense, as a result of Lipson, and the funds were not directly used to create or finance a business interest, her appeal of the CRA assessment failed.

Hershfield made a number of other observations; ironically, if the taxpayer had created a series of highly artificial transactions, reminiscent of Singleton (for example, by transferring the former principal residence to a friend and then immediately buying it back with properly structured financing), she would likely have succeeded in her claim.

@page_break@It is not enough, Hershfield added, that a taxpayer’s situation resembles that of another taxpayer; rather, how they got there is what is important. “At the end of the day, a taxpayer is not able to simply argue that the economic substance of their situation is identical to that of another taxpayer and thereby claim to be entitled to a tax treatment similar to that enjoyed by that other taxpayer,” the judgment says.

Hershfield also noted that it is not the nature of the security for a loan that determines whether the interest is deductible as a business expense. Such considerations are irrelevant, the judge ruled.

It was clear, however, that Hershfield was somewhat uncomfortable with his conclusion. After affirming that, “it is the use of the funds that governs,” not the “why,” he stated: “While this conclusion does not sit easily with my reading of the subject provision [of the Income Tax Act], the authorities that bind me are clear. Distinguishing these authorities and resurrecting [the tax court’s] decision in Singleton would make the administration of the subject provision more difficult than it already appears to be. The law relies on the consistent application of the principles developed by the higher courts and I am bound to follow them.”