The Supreme Court of Canada has ruled against a couple who arranged financial transactions in such a way that resulted in the interest payments on their home mortgage being tax deductible. The ruling was eagerly awaited by tax professionals and is likely to have implications for tax planning in Canada.

In a 4-3 decision upholding lower court rulings, the court said that certain financial transactions made by Earl and Jordanna Lipson were abusive as defined by the general anti-avoidance rule (GAAR) provisions of the Income Tax Act. GAAR is meant to limit the scope of allowable transactions where the Department of Finance deems transactions to function against the intention of tax law.

The case dates back to 1994, when the Lipsons entered into an agreement the buy a home. Ms. Lipson borrowed $562,500 from a bank to buy shares in a family investment company from Mr. Lipson. The couple then obtained a mortgage from a bank for $562,500, using the funds to repay the share loan in full. In his 1994, 1995 and 1996 tax returns, Mr. Lipson deducted the interest on the mortgage loan and reported the taxable dividends on the shares as income where it was applicable.

Subsequently, the Department of National Revenue disallowed those deductions and reassessed the Lipsons. The couple appealed the case to the Tax Court of Canada, but their appeals were dismissed. The Federal Court of Appeal upheld the decision of the Tax Court.

In his majority decision, Supreme Court justice Louis LeBel found that the key problem with the transaction occurred when Mr. Lipson applied Mrs. Lipson’s interest deduction to his income, which he was able to do because as a married couple, the Lipsons have a non-arm’s length relationship.

“The attribution . . . that allowed Mr. Lipson to deduct the interest in order to reduce the tax payable on the dividend income from the shares and other income, which he would not have been able to do were Mrs. Lipson dealing with him at arm’s length, qualifies as abusive tax avoidance,” LeBel wrote.

The Supreme Court’s decision on the Lipson case, coming eight months after the case was heard in April 2008, will have implications for tax planners looking for ways to help clients structure transactions in such a way so they are able to deduct interest on mortgage payments

“If you’re using the attribution rules to shift the deduction of losses back in these types of circumstances, then that’s not going to be acceptable tax planning,” says Elizabeth Johnson, a Toronto-based partner with law firm Wilson & Partners LLP.

In the dissenting opinion, Supreme Court justice Ian Binnie expressed concern about the expansion in the application of GAAR implied by the Lipson decision.

“The GAAR is a weapon that, unless contained by the jurisprudence, could have a widespread, serious and unpredictable effect on legitimate tax planning,” Binnie wrote.

IE