legislation & regulation

Update on regulation: the OSC, IIROC & the MFDA

Advocis — Fri, 27 Feb 2009 21:50:54 GMT

Advocis standing firm on behalf of financial advisors and planners

The Ontario Securities Commission (OSC) has been garnering a lot of attention in the financial press lately, much of which is not particularly complimentary. And the recent request by the Ontario Legislative Assembly's Standing Committee on Government Agencies for submissions on how to improve services means that the level of buzz is climbing fast.

You can be sure that many submissions focus on introducing better policing power to deal with securities crime, including stronger methods of both detecting and deterring fraud. Indeed, the concept of expanded investigative and enforcement powers has been strongly advocated for at the national level, with much op-ed commentary calling for the introduction of a properly funded and independent Canadian securities crime regime, to tackle both the occasional rogue individual as well as systemic, larger-scale investment fraud.

What's behind this drive for a stricter regulatory regime? Many high-profile observers and analysts have concluded that self-regulatory organizations (SROs) like the Investment Industry Regulatory Organization of Canada (IIROC) and the Mutual Fund Dealers Association of Canada (MFDA) cannot adequately monitor for illegal activities, much less provide either the OSC or the police with the information they need in order to act effectively.

Another body of critical comment asserts that the OSC and SROs like IIROC and the MFDA—both of which fall under the aegis of the OSC—are guilty of unilaterally introducing rules and regulations which wrongly penalize your typical financial advisor or planner.

That's why, in its submission to the Standing Committee on Government Agencies, Advocis recommended that the OSC and SROs adopt a uniform and consistent procedure before introducing new regulation, to better understand and lessen the impact of their actions on compliant individual advisors and planners:

We recommend the government impose requirements on the OSC and the SROs to ensure that before implementing any new major regulatory requirement that it develop a clearly articulated statement of the problem that the regulation is meant to address... Failure to identify problems that clearly require intervention, and failure to assess the impact on market participants and consumers in relation to the likely benefits, has led to ill-conceived regulatory initiatives.

In regard to IIROC's implementation of the financial planning rule, Advocis submitted that:

The proposed IIROC rule is an example of SRO regulation that is skewed in favour of large dealers with an employer–employee business model and is severely prejudicial to smaller, professional financial planners. This is also an example of an inadequate consultation process. The proposed rule was issued for comment in the summer of 2008 with a very short response turnaround timeline and without prior consultation with financial advisors.

At a time when consumers of financial services so obviously require the widest possible range of choice in selecting qualified financial advice, the OSC, the MFDA and IIROC are moving ahead with tighter and tighter rules-based regulatory initiatives. Their commitment to prescriptive, rules-based regulation tends to favour larger organizations which have the deep pockets needed to comply with such regulations. However, it is the consumer-responsive and fully compliant but smaller advisory practices which will increasingly pay the price for this style of regulation.

The paradox is that such a regulatory approach ignores or even conflicts with the basic principles which underwrite the mandates of organizations like the MFDA and the OSC. In specific, some of these basic principles which are now in harm's way include foundational concepts such as ease and security of consumer access to necessary services and the ability of the individual to freely choose from the widest range of competent service providers. What's more, in their broadest sense, these principles inform not just the raison d'êtreof our financial regulatory regimes, but also underpin the very basis of our system of political economy. At time when the ability of these organizations to enforce rules and ensure compliance are being called into question by experts near and far, it seems both impolitic and even short-sighted to introduce yet more rules and regulations until enough of the stakeholders arrive at a consensus of what's broken, what needs to be fixed—and, most important of all—what we are certain that we can and should fix.

Lipson, Part II: Singleton shuffle still on the dance card

Advocis — Fri, 30 Jan 2009 17:25:54 GMT

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.

Lipson, Part I: Supreme Court says 'no way' to Lipsons

Advocis — Fri, 30 Jan 2009 17:21:19 GMT

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.

Advocis, advisors & planners, and Dwight Duncan

Advocis — Tue, 20 Jan 2009 19:51:17 GMT

Regulation and the upcoming provincial budget

The current issue of Investment Executive has an article by Megan Harman which outlines Advocis’ position on the need to reduce the regulatory burden faced by advisors and planners in Ontario.

You’re probably aware that Advocis is urging Ontario Finance Minister Dwight Duncan to use this year’s provincial budget as a platform to deal with the regulatory hurdles advisors and planners face.

Advocis’ pre-budget submission to Duncan made the case for the Ministry of Finance to increase its oversight of provincial regulators, especially in regard to the regulation financial advisors and planners routinely experience, as well as the need to protect Ontario consumers with regulation that does not adversely affect their ability to access competent and efficacious financial planning and advice.

Greg Pollock, Advocis president and CEO, is quoted at length in the article:

We are not asking for a handout or a subsidy… Our members simply want to do business in a regulatory environment that not only protects the public, but also ensures that advisors and planners are not hampered by unnecessary and inefficient regulation…

In addition to smart regulation—not one-size-fits-all regulation, we need to see more and better proof of the need for additional regulation. Our members see the regulation but seldom see any indication of an understanding of the size of the problem the regulation is intended to address. A cost-benefit analysis from the regulator about the benefits of protecting the consumer against the increased burden of compliance costs to the financial advisor or planner would go a long way.

Smarter regulation that’s backed by a convincing cost-benefit analysis in the consumer interest: we can think of no better time that the right now for this concept to gain purchase in the Ministry of Finance’s offices. For the moment, we will await Duncan’s budget and see what he does.

Click here for to read the entire article online at Investment Executive.