The Supreme Court of Canada will hear an appeal tomorrow in a case called Lipson v. Canada. The appeal may prove to be a significant test of the efficacy of the so-called "general anti-avoidance rule" (the "GAAR") in combatting what is perceived to be abusive tax avoidance.
The Lipsons engaged in a series of transactions over two days in 1994 in which they made use of various rules, including the spousal rollover rule (section 73), the spousal attribution rule (section 74.1), and the back-to-back loans rule (subsection 20(3)), to transform what would otherwise have been non-deductible mortgage interest under paragraph 20(1)(c) into, they argue, deductible interest under paragraph 20(1)(c).
The Lipsons have lost previously at the Tax Court of Canada and at the Federal Court of Appeal. It is not at all obvious, however, that the Lipsons will lose at the Supreme Court of Canada.
The facts are as follows.
Earl and Jordanna Lipson were a married couple. On April 24, 1994, they entered into an agreement of purchase and sale to purchase a personal residence for $750,000 with a $50,000 deposit. On August 27, 1994, the Lipsons signed a letter addressed to their solicitor stating that the Bank of Montreal was lending them $562,500 on September 1, 1994 to place a mortgage on the new property.
On August 31, 1994, the following transactions occurred:
- Jordanna borrowed $562,500 from the bank;
- Earl transferred 20 and 5/6th shares of Lipson Family Investments Limited to Jordanna for $562,500, which was the fair market value of the shares;
- Jordanna gave Earl a cheque for $562,500 as payment for the shares;
- Earl forwarded the funds to the solicitor handling the purchase of the property.
On September 1, 1994, the following transactions occurred:
- the Transfer/Deed of Land, showing Earl and Jordanna as joint tenants, was registered;
- the Charge/Mortgage of Land was registered;
- the solicitor used the funds received from Earl on August 31, 1994 to pay $562,500 towards the purchase price of the property;
- the bank advanced $562,500 to the solicitor as proceeds from the mortgage on the property;
- the solicitor used the $562,500 proceeds from the mortgage to repay Jordanna's loan.
Earl did not elect not to have subsection 73(1) of the Income Tax Act apply to the transfer of the shares to Jordanna. The Lipsons claim entitlement to the following tax consequences as a result:
- the shares are deemed to have been sold by Earl for proceeds equal to his adjusted cost base ("ACB") of the shares and to have been acquired by Jordanna at the same ACB so that no taxable gain or loss would arise until the shares were sold by Jordanna; and
- any income or loss from the shares computed in the hands of Jordanna is deemed to be that of the Earl under subsection 74.1(1) of the Act.
The Lipsons claim that the steps they take should effectively result in the mortgage interest becoming deductible.
The Minister has argued that the GAAR should apply to nullify the deductbility of the interest expenses on the mortgage. For the GAAR to apply, three factors must be present: (i) there must be an identifiable tax benefit; (ii) an avoidance transaction engaged in by the taxpayer; and (iii) it must be reasonable to consider that the transaction or series of transactions amounts to a "misuse" or "abuse" of the Income Tax Act (and/or related instruments).
In this case, the tax benefit is clear. Earl claims to be entited to deduct the losses accruing to Jordanna on the shares she purchased from him. This deduction is clearly a tax benefit.
That there is an avoidance transaction is also obvious. There is no reason other than securing for Earl the tax benefits to have Earl sell the shares to Jordanna. In fact, it is essential that the tax attributes of the shares do not actually pass to Jordanna for the scheme to work. Legal title to the shares passes, but all the tax incidents remain with Earl because of section 74.1. Thus, there is an avoidance transaction.
The pivotal question for the Court will be how to frame the analysis of whether there is a misuse or abuse. One question surrounding this inquiry will be whether the Court should apply the "old" language of subsection 245(4), or the "new" language of subsection 245(4), which was introduced with retroactive effect to 1988 in May 2005. I have written about this elsewhere. It is fairly clear in this case that is should be the new language of subsection 245(4).
The strongest basis on which an abuse or misuse can be found is in the use of the income-splitting rule, section 74.1. The intention of section 74.1 is to attribute back to a transferor spouse income from property transferred to a lower income spouse so as to make the individual tax unit efficacious. The Lipsons planned to use this provision to transfer anticipated losses (losses they entirely controlled by virtue of the corporation being a family holding company) to the higher income spouse. Even if nothing else that the Lipsons did constituted a misuse or abuse (unlikely, in my view), this use of section 74.1 was deliberate, calculated and, in my view, sufficient for the Court to dismiss the appeal.