Unlike the Singleton case, here the Court looks at the general anti-avoidance rule
The Supreme Court of Canada dismisses the appeal of Earl and Jordan B. Lipson and upholds Tax Court's earlier decision that they breached the general anti-avoidance rule or “GAAR.”
Most advisors and planners now know that on January 8, 2009, the Supreme Court of Canada released its decision on the Lipson appeal.
Here’s the decision, in brief:
Earl Lipson and his wife Jordana Lipson entered into an agreement of purchase and sale for their family residence. Jordana borrowed $562,500 from a bank to finance the purchase of shares in a family corporation. She paid the borrowed money directly to her husband who then transferred the shares to her. Lipson and his wife then obtained a bank mortgage for $562,500. Later that same day, they used the mortgage loan funds to repay the entirety of the share loan. For a three year period—1994, 1995 and 1996 (justice moves slowly!)—Lispon deducted the interest on the mortgage loan and reported the taxable dividends on the shares as income whenever applicable. However, the Canadian Revenue Agency disallowed the deductions for those taxation years and reassessed the Lipson accordingly. The Tax Court of Canada dismissed the Lipsons' appeals (Lipson’s brother had also performed a similar set of transactions), ruling that the transactions constituted a misuse of ss. 20(1)(c), 20(3), 73(1) and 74.1 of the Income Tax Act and the taxpayers’ appeals were dismissed. The Federal Court of Appeal upheld that decision and at long last the case reached the Supreme Court of Canada.
In a 4-3 split, the Court dismissed the Lipson's appeal and confirmed the application of the general anti-avoidance rule or the GAAR to the transaction at issue. The Court noted that that there was no dispute regarding the general tax deductibility of interest expenses under s. 20(1)(c) and s. 20(3) of the Income Tax Act.
Rather, it was the spousal issue which caused the Court to rule that GAAR was applicable:
It has long been a principle of tax law that taxpayers may order their affairs so as to minimize the amount of tax payable. However, this principle has never been absolute, and Parliament has enacted the ... to limit the scope of allowable avoidance transactions while maintaining certainty for taxpayers...
The Court focused on was how the Lipsons handled the transfer of shares.
After determining that the GAAR did apply, the majority of the court found that the use of the attribution provisions of the Income Tax Act was abusive. In particular, the use of the attribution provisions let Lipson reduce his income tax from what it would have been had he and his wife been dealing at arms-length—that is, the rules resulted in a tax benefit to which Lipson would not have otherwise been entitled.
The Court reasoned that the series of transactions did not become problematic until Lipson and his wife turned to the spousal attribution rules, which resulted in Lipson applying his wife's interest deduction to his own income. That is, the attribution rule was used by Lipson to permit him to in effective deduct his wife's interest expenses—something he could not have done if he and his wife were not married. And therein lay the problem, for the Court found that the purpose of the attribution rule is to prevent spouses from reducing tax by attempting to use to their advantage their non-arm's length relationship when transferring property between them.
Before the shares were transferred from Lipson to his wife, dividends on the shares were taxable and Lipson could not deduct any interest expense. After the sale of the shares to Mrs. Lipson, income on the dividends was still taxable back to Lipson—but the employment of the attribution rules to the Lipson's advantage meant that the interest expense could be claimed by Lipson—a situation that frustrated the purpose of the attribution rules and therefore qualified as “abusive tax avoidance."
The GAAR's application was the focus of the appeals and was the proper basis for the reassessments of the transactions. These transactions are caught by the GAAR. Courts should avoid extending the GAAR beyond its statutory purpose. But, bearing this purpose in mind, where the language of and principles flowing from the GAAR apply to a transaction, the court should not refuse to apply it on the ground that a more specific provision—one that both the Minister and the taxpayers considered to be inapplicable throughout the proceedings—might also apply to the transaction.
Finally, in determining the tax consequences of the GAAR's application under s. 245(5), courts must be satisfied that an avoidance transaction has been found under s. 245(4), that s. 245(5) provides for the tax consequences and that they deny the tax benefits that would flow from the abusive transactions. Courts must then determine whether these tax consequences are reasonable in the circumstances. In the present case, the disallowance of the interest expense in computing the income or loss attributed to the taxpayer and allocation of that interest deduction back to his wife is a reasonable outcome.
In the next posting we’ll look at the specifics of the Court’s decision and what it means for advisors and planners moving forward.