Although Canadians can structure their borrowing arrangements to obtain interest deductions to minimize their taxes, their tax planning strategies must not only comply with the letter of the Income Tax Act but also its “object, spirit and purpose.” Otherwise, the Canada Revenue Agency can disallow deductions deemed to be abusive to the tax system.

Essentially, the CRA can apply the general anti-avoidance rule to deny taxpayers interest deductions in certain instances; that is, if a transaction or series of transactions can be deemed to be motivated by abusive tax avoidance.

Generally, interest on borrowed money is deductible if the money is used for earning income from a business or property. Interest paid on money to finance personal purchases is not deductible, in most cases.

The Supreme Court of Canada’s Jan. 8 decision in the case of Earl Lipson and his wife, Jordana, which was ultimately decided on the GAAR, supports the ability of taxpayers to structure their affairs to take advantage of interest deductions but also creates uncertainty over how the application of the GAAR may impede taxpayers’ ability to do so.

In reality, says Brian Carr, a partner with Toronto-based Moskowitz & Meredith LLP, a law firm affiliated with KPMG LLP in Canada: “99% of interest-deduction transactions are not subject to GAAR. [But] the Lipsons were overly aggressive.”

Put simply, the Lipsons engaged in a complicated transaction to make the mortgage interest on their home tax-deductible.

In 1994, the couple agreed to purchase a house for $750,000. On the day before the closing of the purchase, Jordana Lipson borrowed $562,500 from a bank to finance the purchase of shares in her husband’s private investment company. Earl Lipson then used the proceeds of sale of the shares to close the purchase of the house. On the day after the purchase, another loan was obtained by the couple from the same bank, secured by a mortgage on the house. This loan was used to repay the original loan used by Jordana Lipson to acquire the shares.

As Jordana Lipson had borrowed money to acquire shares in her husband’s company, she was entitled to deduct that loan’s interest. Given that the shares were transferred to Jordana Lipson on a rollover basis, the transfer was deemed to have taken place at Earl Lipson’s adjusted cost base, not fair market value. Consequently, no capital gains were realized on the sale of the shares.

As a result, the tax-free transfer triggered the ITA’s spousal attribution rule, which states that any income or loss realized on transferred assets must be attributed to the spouse who transferred the assets. In this case, Earl Lipson.

Accordingly, Earl Lipson relied on the spousal attribution rule to deduct the mortgage interest over the following three years. In his opinion, the mortgage replaced Jordana Lipson’s loan, which was then used to acquire the shares that are income-producing property. He also included dividends that were paid to his wife on the shares as income on his tax return; again, he was applying the attribution rule.

Although it would appear that Earl Lipson was following the letter of the ITA, the CRA prohibited the interest deduction, claiming that the transactions were abusive because the Lipsons’ sole purpose was to borrow money to purchase the home and not the shares. Essentially, the Lipsons had converted non-deductible mortgage interest on a personal home in order to avoid paying taxes.

The CRA argued that the “object, spirit and purpose” of the spousal attribution rule embodies an anti-avoidance provision aimed at preventing income-splitting. Consequently, the CRA took the position that using this provision to avoid taxes is contrary to the purpose of the spousal attribution rule and is therefore a misuse and abuse of the provision. Accordingly, the CRA applied the GAAR to deny the deduction.

The Lipsons did not deny that the transactions were aimed at tax avoidance. However, they argued that they were not abusively avoiding taxes, as they were adhering to the spousal attribution rules. Upon appeal, both the Tax Court of Canada and the Federal Court of Appeal agreed with the CRA.

An appeal to the SCC upheld the lower courts’ rulings, but the SCC’s seven-member panel was split 4-2-1 in its decision — with two sets of dissenting minority opinions.

Writing on behalf of the majority, Justice Louis LeBel stated: “The tax benefit of the interest deduction resulting from the refinancing of the shares of the family corporation by Mrs. Lipson is not abusive viewed in isolation. The ensuing tax benefit of the attribution of Mrs. Lipson’s interest deduction to Mr. Lipson is.”

@page_break@In fact, says William Innes, a counsellor in the Toronto office of law firm Fraser Milner Casgrain LLP: “All three sets of decisions agreed that the interest deduction in the hands Mrs. Lipson did not constitute a misuse or abuse of the ITA.”

What this means is that Jordana Lipson could have deducted the mortgage interest even though a personal property was acquired.

The SCC majority argued that while care should be taken in evaluating the “overall purpose” of a transaction or series of transactions in determining abusive tax avoidance, the “overall result” more accurately reflects the appropriate test for the application of the GAAR.

The two dissenting opinions did not support the application of the GAAR. The first dissenting opinion stated that the CRA did not identify a clear and specific policy in arguing its case; the CRA resorted to vague generalities and “overriding policy,” thereby resulting in increased uncertainty in tax planning.

The other SCC dissenting opinion stated: “There is no reason why taxpayers may not arrange their affairs so as to finance personal assets out of equity and income-earning assets out of debt.”

The SCC majority found that taxpayers are not allowed to use the attribution rule in this case, while the minority found that they can, says Peter Megoudis, a senior manager in the Toronto office of Deloitte & Touche LLP: “The taxpayers did exactly what the ITA allows.”

Throughout the Lipson case, reference was made to the Singleton case, which remains a benchmark for interest deductibility. In this case, John Singleton, a partner in a law firm, withdrew money from his partnership capital account and used the funds to purchase a house. He then borrowed money to replace the withdrawn capital and then deducted the interest on the borrowed money on the premise that the money was used to earn income from the partnership.

Singleton won his ability to claim the interest deduction in a March 2001 SCC decision after losing in the lower courts. The SCC’s decision stated: “If a direct link can be drawn between the borrowed money and an eligible use, then the money was used for the purpose of earning income from a business or property.”

Today, the “Singleton Shuffle” remains a popular interest-deductibility strategy. So, why did Lipson lose and Singleton win?

“Lipson lost because of the spousal twist and his reliance on the attribution rules,” argues Mitchell Thaw, a partner in the Toronto office of law firm Fasken Martineau DuMoulin LLP.

Innes adds: “The Lipsons’ preponderant motivation was tax-driven. They had no business motivation or astute tax-planning strategy.”

“Lipson is a clear signal that you must be wary if you want to use the attribution rules,” says Elizabeth Johnson, a partner with Toronto law firm Wilson & Partners LLP.

Another important interest-deductibility case is that of Ludco Enterprises Ltd. In this case, Ludco deducted $6 million in interest on money borrowed to buy shares in foreign corporations. Ludco received $6 million in dividend income from its investments. It later sold the shares for a capital gain of $9.2 million. The CRA denied the interest deduction. Ludco lost its appeal in the lower courts, but won in the SCC.

The SCC stated that Ludco had a reasonable expectation of earning an income — not necessarily a profit. It noted that Ludco earned dividend income, resulting from borrowed funds. The “use” of borrowed money for income-earning purposes played an important role in the final determination of this case. In interpreting “use,” the courts typically consider “first used” or “currently used.” In most cases, the SCC leans toward “currently used,” as it did in the Ludco case.

One important decision that came out of the Ludco case, Thaw says, is that “you do not necessarily have to earn a positive net income in order to deduct interest.”

Going back even further, Innes says, “The Bronfman case is the starting point for cases on interest deductibility.”

In this 1987 case, the Phyllis Barbara Bronfman Trust elected to make discretionary capital allocations to its beneficiary. Instead of liquidating capital assets to make the allocations, the trustees borrowed money from a bank and deducted the interest on the borrowed funds, which were grossly in excess of the amount saved by not selling the assets to meet the allocations.

Following the Bronfman Trust victory in the SCC, the CRA took the position that taxpayers must be able to trace borrowed funds to an eligible use when claiming an interest deduction. The word “trace” has since been changed to “link” in the Singleton case, which affirms the deduction of interest even after Lipson.

But after all this time, a lot of uncertainty still surrounds interest deductibility. Says Thaw: “Draft legislation has been on the drawing board for many years.”

Adds Innes: “There still remains a lot of concern for tax planners; it’s hard to get definitive answers.” IE