Supreme Court rules against Lipson

The Supreme Court of Canada has dismissed the appeal of Earl and Jordan B. Lipson, upholding the earlier decision by the Tax Court that the pair had breached the general anti-avoidance rule (GAAR).

The decision was split, with three of the seven justices dissenting. In the written decision, the majority said:

“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 1994, Earl Lipson and his wife Jordanna used a variation of the “Singleton Shuffle” to make the interest on their mortgage tax deductible. The Singleton Shuffle itself has not been struck down by today’s decision — where the couple ran afoul of the GAAR was in their attribution of deductions.

Mrs. Lipson borrowed $562,500 in order to purchase shares in the family corporation, Lipson Family Investments Limited. While she did not have sufficient income to qualify for the loan, the Bank of Montreal made the loan anyway, because Mr. Lipson agreed to repay it in its entirety the following day. Mrs. Lipson paid her husband for the shares.

The pair then took out a mortgage with the Bank of Montreal, again, for $562,500. This amount was used to pay back the first loan.

Mr. Lipson deducted the interest on the mortgage from his taxes for 1994, 1995 and 1996, totaling nearly $105,000 over the three years. He used four provisions in the Income Tax Act to justify this deduction. Under section 73(1), taxpayers may defer tax on interspousal transfers of property. He was entitled to opt out of this provision, but did not. Lipson’s share transfer was deemed to have been made at his adjusted cost base, rather than at fair market value, so he neither sustained a loss nor realized a gain on the sale.

The second provision he relied on was section 74.1, which attributes any income or loss realized through an interspousal property transfer to the transferring spouse for tax purposes. While Mrs. Lipson owned the shares in the family corporation, the dividend income and losses were attributed to her husband.

Section 20(3) allows the deduction of interest on loans taken out to make an investment. Although the shares were paid for with the proceeds of the first (non-mortgage) loan, the mortgage loan was treated as having funded the share purchase.

Mr. Lipson deducted the interest on the mortgage loan pursuant to section 20(1)(c), which permits the deduction of interest on money borrowed “for the purpose of earning income from a business or property.” Using the attribution rule (section 74.1), Lipson attributed both the dividend income from the family corporation shares and the interest expense to himself.

The Ministry of National Revenue disallowed the interest deductions, saying the true economic purpose for borrowing the money was not to earn income and that the interest was therefore not deductible. This rationale was shot down by the Tax Court of Canada, but the ministry then claimed Lipson violated the GAAR, claiming the transactions amounted to abusive tax avoidance.

Justice William Binnie and Justice Marie Deschamps defended Lipson’s strategy, however, writing:

“While the legal relationships actually created by the taxpayer do not control the application of the GAAR, they cannot be ignored. Here, the application of the GAAR would mean paying lip service to the principle that taxpayers are entitled to arrange their affairs to minimize the amount of tax payable, without taking seriously its role in promoting consistency, predictability and fairness in the tax system.”

The same strategy was used by Lipson’s brother, Jordan B. Lipson, the second appellant in the case.

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(01/08/09)