To the relief of many, taxpayers can probably still arrange their financial affairs to transform the interest on a home mortgage into a deductible expense, given the January decision of the Supreme Court of Canada in Lipson v. Canada. But the court also rapped taxpayers’ knuckles for using the attribution rules to transfer the deduction from one spouse to another.

“I see the decision in Lipson as good news,” says Jamie Golombek, managing director of tax and estate planning with CIBC Private Wealth Management in Toronto. “In the case of a plain-vanilla debt-swap strategy, you can feel comfortable in the fact that you can rearrange your affairs to minimize taxes and get an interest deduction.”

In the long-awaited decision, the top court ruled four to three against taxpayer Earl Lipson. Lipson and his wife, Jordanna Lipson, had executed a series of transactions while buying a home that effectively swapped a personal mortgage debt for a business debt. The couple also used the attribution rules to transfer the resulting deduction for the interest to the husband from the wife. It was the use of the attribution rules in combination with the debt swap that the majority of the court found abusive under the Income Tax Act’s general anti-avoidance rules.

But while the Lipsons lost on the attribution issue, the judgment in general favours taxpayers, tax experts say. That’s because the Lipson decision appears to leave the SCC’s 2001 ruling in Singleton v. Canada undisturbed. In that case, the court found in favour of a Vancouver lawyer who had borrowed capital from his law practice to pay for his house and then took out a mortgage on the house to repay the capital, thus transforming his home mortgage into a business loan — with tax-deductible interest.

The manoeuvre became known as the “Singleton shuffle” and tax experts have been anxiously waiting to see if the final result in Lipson would dovetail with Singleton, especially after two lower courts ruled that the Lipsons’ mortgage interest was not deductible.

“The reason so many of us in the tax community were concerned about Lipson,” says Heather Evans, a tax partner with Deloitte & Touche LLP in Toronto, “is that we didn’t really see a material difference between that case and Singleton — at least, in regard to interest deductibility.

“With the decision, we now have clarity around the fact that it’s OK to use your equity and your borrowing in a way that’s tax-effective,” she adds. “And you can rearrange your personal finances in such a way as to get there. But the other message from the ruling is that you have to be extremely careful if you couple that with any other [tax] planning.”

The Lipson situation dates back to 1994, when the Lipsons entered into an agreement to buy a home. Jordanna borrowed $562,500 from a bank, which she used to buy shares in a corporation owned by her husband. Under an exception to the general attribution rules — which are designed to limit income-splitting by related persons, usually spouses — they used a rollover for the share transfer. Earl thus was able to create income from the shares without realizing a capital gain.

Earl then took the $562,500, tax-free funds he had received from his wife and used them to purchase the home. The couple then obtained a mortgage from a bank for $562,500, and used the funds to repay in full the original loan that had been obtained for business purposes to buy the shares.

If the parties had not been married, the interest on the business loan, as well as the income from the shares, would have been assessed in the hands of Jordanna. But the tax benefit was greater if Earl took the deduction. To create that advantage, the Lipsons used the attribution rules to transfer the deductibility of the interest to Earl. While those rules were designed as an anti-avoidance scheme, the Lipsons effectively used them, together with the provisions permitting rollovers between spouses, and the debt swap to lower their taxes.

In Earl’s 1994, 1995 and 1996 tax returns, he deducted the interest on the mortgage loan and reported as income the taxable dividends received by his wife from the shares. Subsequently, the Canada Revenue Agency disallowed those deductions under the general anti-avoidance rule as an abusive form of tax avoidance and reassessed the Lipsons. The couple appealed to the Tax Court of Canada but lost. The Federal Court of Appeal upheld that decision. Both of those judgments turned on findings that the overall purpose of the whole series of transactions was to create deductible interest on money used to buy a home, with the CRA successfully arguing that the series of transactions violated the GAAR.

@page_break@When the case was heard by the SCC in April 2008, the question of mortgage interest deductibility as part of the whole series of transactions was the focus of legal arguments. But to the surprise of many, the final decision of the SCC instead turned on the role of the attribution rules when used in the context of a series of transactions designed to avoid taxes.

None of the judges took issue with the substitution of one debt for another, thus creating mortgage interest that was deductible. But the SCC was divided sharply on who should be able to take the deduction. In the majority judgment, Justice Louis LeBel focused on the overall “object” and “purpose” of the attribution rules; the SCC has previously ruled that this test is central to assessing abusive tax avoidance.

In holding that the Lipson transaction unlawfully frustrated the attribution rules, LeBel wrote that the purpose of those rules is to “prevent spouses (and other related persons) from reducing taxes by taking advantage of their non-arms’ length status when transferring property between themselves.”

Essentially, LeBel wrote that the attribution rules cannot be used to achieve a result that is the opposite of what he viewed as their purpose: “[To] allow s. 74.1(1) to be used to reduce Mr. Lipson’s income tax from what it would have been without the transfer to his spouse would frustrate the purpose of the attribution rules. Indeed, a specific anti-avoidance rule is being used to facilitate abusive tax avoidance.”

In addition, the majority ruling commented on the appropriate use of the GAAR by the CRA, saying that the CRA can use the GAAR specifically to combat “the impact of complex series of transactions which often depend on the interplay of discrete provisions of the [Income Tax Act].”

The ruling acknowledged that when used this way, the impact of the GAAR may introduce “a degree of uncertainty into tax planning.” But, the ruling also asserted, “The GAAR is neither a penal provision nor a hammer to pound taxpayers into submission.”

A dissenting opinion, written by Justice Ian Binnie, takes direct issue with LeBel’s conclusions on both fronts. When assessing the purpose of the attribution rules, Binnie used an analysis based on the specific mechanics of the attribution rules rather than the more general approach of the majority ruling. “In my respectful view, what LeBel believes s. 74.1(1) is designed to prevent is actually a reasonable statement of what s. 74.1(1) seeks to permit,” Binnie wrote, adding that the section expressly allows rollovers between spouses when they wish to avoid a capital gain, with the proviso that income or losses from the transferred property are attributed back to the person making the transfer.

Binnie also disagreed with LeBel’s view of the GAAR, saying the GAAR has the potential to be “a weapon that, unless contained by the jurisprudence, could have a widespread, serious and unpredictable effect on legitimate tax planning.”

In a second dissenting opinion, Justice Marshall Rothstein wrote that a specific anti-avoidance rule covering the use of attribution should have applied to the case, negating the need to use the GAAR. As the government had not raised that rule when arguing its case, Rothstein would have decided in the Lipsons’ favour.

Overall, Lipson has implications for tax planning that are mostly positive, given the SCC’s decision not to attack the basic deductibility of the interest on these types of mortgages. The court held the Lipsons’ mortgage interest could be deducted, but only by Jordanna. Clearly, there are now caution flags around use of the attribution rules in this context. “If you’re using the attribution rules to shift the deduction of losses back in these types of circumstances,” notes Elizabeth Johnson, a partner with law firm Wilson & Partners LLP in Toronto, “then that’s not going to be acceptable tax planning.”

On the GAAR point, however, tax experts appear to agree that Lipson may have served only to muddy the waters in terms of how the GAAR is to be understood and applied. “The court said that GAAR has to be interpreted in a way that provides taxpayers with certainty, predictability, and fairness,” says Evans. “The reasons given in the majority decision, I would say, fall short of that.”

The lack of consensus from the seven-member panel, with two dissents — one strongly worded — and the absence of Chief Justice Beverly McLaughlin (who stepped down in order to create an odd-numbered panel in the absence of a fully staffed court) also could have a chilling effect, not only on tax advi-sors and their clients but on the government as well, according to Ed Kroft, counsel for the Lipsons and a partner in the tax group of McCarthy Tétrault LLP in Vancouver.

“The question now becomes,” Kroft says, “how active will the CRA be with respect to applying the GAAR and what will lower-court judges do with respect to the application of the GAAR, seeing the disagreement by the judges on the Supreme Court? It shows that there is litigation risk, not just for taxpayers but also the Crown.” IE