A popular tax-planning strategy known as the “Singleton shuffle” appears to have been struck down by the Tax Court of Canada. Advisors may want to caution their clients against trying it.

The strategy involves a taxpayer selling non-registered securities and using the money to pay a mortgage. The taxpayer then takes out a loan, such as a line of credit, to repurchase the securities. Using the strategy, interest on the loan is then claimed as a tax deduction.

The Tax Court, however, now says this type of strategy can be struck down by the “general anti-avoidance rule.”

The main aspect of GAAR is contained in Section 245(2) of the Income Tax Act, which states that if the Canada Revenue Agency determines that a taxpayer transaction is an “avoidance transaction,” then any tax benefit arising from the transaction will be denied. Although GAAR has been part of the Income Tax Act since 1988, the CRA has rarely used it.

In October 2005, the Supreme Court of Canada released two decisions — the first GAAR cases to go before the country’s top court. In these two cases, The Queen v. Canada Trustco Mortgage Co. and Mathew v. Canada, which involved complex corporate transactions, the SCC established a three-point test for determining if GAAR is applicable:

> there must be a tax benefit, such as a reduction or deferral of taxes;

> the transaction or series of transactions will be considered an avoidance transaction if it wasn’t “reasonably undertaken or arranged primarily for a bona fide purpose other than to obtain a tax benefit;” and

> the transaction is abusive in the sense that it cannot be reasonably concluded that the tax benefit would be consistent with the “object, spirit or purpose” of the tax act provisions that the taxpayer is relying upon to enable the transaction.

The taxpayer bears the burden of refuting the first two elements of the test. The CRA must prove the third.

Tax strategists consider GAAR an ominous tool that the CRA can use to deny clients the benefits of tax planning. Since last October, the lower courts have released nine GAAR decisions, including Lipson v. the Queen, the case that calls into question the Singleton shuffle.

The principal weapon that clients can use to fight a CRA allegation that GAAR should be applied is that there is a bona fide reason for the transaction under scrutiny other than taxes, such as business profit or estate planning, says Rob MacKnight, partner and tax lawyer with Wilson Vukelich LLP in Markham, Ont.

But establishing the non-tax purpose is not easy.

The SCC also wrote that in a situation in which it is unclear whether abuse has occurred, “the benefit of the doubt goes to the taxpayer.” It seems, however, that taxpayers who use the Singleton shuffle won’t get the benefit of the doubt.

“Now maybe GAAR applies,” says Jamie Golombek, vice president of taxation and estate planning at Toronto-based Aim Funds Management Inc.

In Singleton v. Canada, Van-couver lawyer John Singleton withdrew $300,000 from the capital account of his law firm and combined the funds with money from his wife to buy a home. On the same day, he borrowed the same amount from a bank and repaid the firm’s capital account. On his tax return, he deducted more than $20,000 in interest expenses.

The CRA denied the deduction. The Tax Court agreed, stating: “The fundamental purpose was the purchase of a house, and this purpose cannot be altered by the shuffle of cheques that took place.” Hence, the name: Singleton shuffle.

But the Federal Court of Appeal and the SCC disagreed with the Tax Court. The SCC stated that taxpayers “are entitled to structure their transactions in a manner that reduces taxes, and the fact that the structures may be complex arrangements does not remove the right to do so.”

It was precisely the “shuffle of cheques” that defined “the legal relationship [that] must be given effect,” the SCC wrote.

Shortly after the Singleton decision, the CRA announced a review of interest deductibility, which is still ongoing. The impact of Singleton had not been addressed until the Lipson case.

In Lipson, the taxpayer and his wife tried to use a Singleton-type strategy. First, Jordana Lipson paid $562,000 to purchase shares in a family company from her husband, Earl. She financed the purchase with a bank loan. Then Earl took out a $562,000 mortgage on their house to repay the bank loan.

@page_break@The transaction was structured so that any gain or loss on the shares would be deemed to be Earl’s. He wanted to claim the interest expense on the loan, net of any dividend income earned on the shares. Both Lipsons were reassessed and lost their appeals.

The Tax Court noted the flaws in the Lipsons’ scheme. “It does strike me as passing strange that Earl should get a deduction for interest on money borrowed ostensibly to enable [his wife] to buy his shares,” wrote Chief Justice Donald Bowman.

He concluded: “Paragraph 20(1)(c) was intended to permit interest on money borrowed for commercial purposes to be deducted. The corollary is that interest on money borrowed for personal use, such as buying a residence, is not deductible.”

The Singleton case centred on the same tax provision, which allows taxpayers to claim an interest deduction on financing for “the purpose of earning income from a business of property.”

However, the Lipson case did not involve the same factual complications as Singleton, which means it probably will not be appealed, says MacKnight. It also didn’t involve the CRA advancing its position based on GAAR.

Since the SCC decisions, GAAR has come up in nine lower court cases — in the Tax Court of Canada and the Court of Quebec. The score so far: taxpayer 5, CRA 4.

Unfortunately for your clients, Lipson was a CRA win. IE