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.”
Converting equity into deductible debt: what the Court said
One of the more comforting conclusions offered by Lipson is that the Supreme Court once again confirmed the general principle that interest on investment loans is tax-deductible.
Also of particular importance to advisors is the fact that the Court explicitly stated that the Lipson’s ploy is to be distinguished from the transaction at issue in the 2001 Supreme Court Case of Singleton, where the interest was ultimately found to be properly tax deductible.
You’ll recall that in Singleton, a partner in a law firm borrowed money that he had built up in his law firm capital account and used it to pay off his mortgage. He then borrowed that money back to pay off his capital-account loan at the firm and sought to deduct the loan interest. The Canada Revenue Agency challenged the transaction, but lost at the Supreme Court.
Moreover, in Singleton neither GAAR nor spousal attribution rules were issues before the Court, further reinforcing the conclusion that the Lipson decision should not affect financial planning which strictly derives from the fact pattern in Singleton.
But what of Lipson’s impact on the larger issue of debt-swap strategies generated from the Singleton decision—which are commonly referred to as the "Singleton Shuffle"? These are strategies based on the proposition that one can arrange one’s financial affairs in a tax-efficient manner and make one’s interest on investment loans tax-deductible.
The law, as all advisors know, is that interest on a loan for commercial purposes is deductible. This means that investors may borrow money to acquire income-producing assets, such as shares or rental property, and then deduct that against income. However, when loan money is used for a personal purpose, like purchasing a house in order to live in it, no deduction is permitted.
As you know, this is where Singleton-style planning comes in, with its plethora of strategies designed to capitalize on interest deductibility. These strategies are used many Canadians who own non-registered assets: typically an advisor suggests they sell these assets and use the resulting proceeds to pay off their mortgage. The investor then gets a loan secured by his or her new home equity, and uses the loan for the purpose of earning investment income from a non-registered account. The result that interest on the loan is fully tax-deductible. This strategy of “shuffling” assets converts non-deductible mortgage interest into a deductible investment loan.
It seems safe to say, according to the text of the Lipson ruling, that Singleton shuffles are still permissible and will not invoke the application of the GAAR. In specific, the Court’s opinion was that the Canadian Revenue Agency:
has not established that in view of their purpose (the interest deductibility) provisions have been misused and abused. Mrs. Lipson financed the purchase of income-producing property with debt, whereas Mr. Lipson financed the purchase of the residence with equity. To this point, the transactions were unimpeachable. They became problematic when the parties took further steps in their series of transactions.
The Court found that both borrowing for the shares and the purchase of the house were "unimpeachable." The Court further found that the Income Tax Act’s interest provisions were not "misused and abused." Indeed, it was only the "spousal twist" and the reliance on the attribution rules that made the Court find the transaction to be abusive under the GAAR.
In other words: Singleton-style debt-swap refinancing still appears to be perfectly legal, minus the Lipson twist.
Further impact on advisors, planners and clients
Obviously Lipson is a key decision for tax planners, since it further refines the area of what constitutes acceptable tax planning that began in Singleton.
Whenever the Supreme Court rules on a matter of direct relevance to financial services professionals, a certain amount of uncertainty is bound to result. Indeed, the Court noted that:
the GAAR may introduce a degree of uncertainty into tax planning, but such uncertainty is inherent in all situations in which the law must be applied to unique facts … [but] the GAAR is neither a penal provision nor a hammer to pound taxpayers into submission. It is designed ... to restrain abusive tax avoidance and to make sure that the fairness of the tax system is preserved.
What is certain is that the Court’s decision in Lipson must be carefully considered in all financial planning strategies involving interest deductibility, and especially when spousal loans are proposed.
Looking ahead, the fact that the Supreme Court split 4-3 in a ruling that the Lipsons’ tax-planning strategy was sufficiently abusive to be captured by the GAAR will contribute to a further lack of certainty for advisors and planners involved in sophisticated debt swap schemes and family members.
The bottom line? For advisors and their clients, the decision is both good and bad, The positive side is that your clients can still borrow money against the equity in their homes and use the proceeds to invest in, say, the market, and reap the benefit of tax deductible interest. The negative side is that the case may mean it is now easier for the Canada Revenue Agency to invoke the GAAR, with further uncertainty in providing advice and planning the end result.
The full text of the Supreme Court’s decision in Lipson v. Canada is available here.