By Kim G C Moody CA, TEP and Marissa L Halil LLB, BCL
The Supreme Court of Canada released its long awaited decision in Lipson v. Canada1 yesterday. The facts in Lipson were, very generally, as follows:
- The taxpayer and his wife entered into a legal agreement to purchase a family residence.
- The wife borrowed $562,500 from a bank to finance the purchase of shares in a family corporation from the taxpayer (relying on the tax deferred provisions of section 73 of the Income Tax Act (the “Act”) resulting in no tax to be payable as a result of the transfer).
- The wife paid the borrowed money directly to the taxpayer who transferred the shares to her.
- The taxpayer and his wife obtained a mortgage from a bank on the new family residence for $562,500. That same day, they used the mortgage loan funds to repay the share loan in its entirety.
- On his 1994, 1995 and 1996 tax returns, the taxpayer deducted the interest on the mortgage loan and reported the taxable dividends received on the shares as income when applicable (relying on the normal “attribution rules” under subsection 74.1(1) of the Act to achieve the desired deduction of interest).
The CRA had assessed the taxpayer utilizing the general anti-avoidance rule (the “GAAR”) under section 245 of the Act to deny the interest deduction claimed by the taxpayer arguing that the series of transactions was abusive tax avoidance. After the Minister of National Revenue was successful at both the Tax Court of Canada and the Federal Court of Appeal, the taxpayer appealed to the Supreme Court of Canada. The decision of the Supreme Court was split 4-3 in favor of the Minister. The majority decision, written by Justice LeBel, held that the GAAR would apply to disallow the deduction of the interest by the husband. Interestingly, the Court stated that, viewed in isolation, the deduction of interest by the wife was not abusive when the taxpayer and his wife turned to subsections 73(1) and 74.1(1) to obtain the desired results. According to the majority:
“(…)s. 74.1 is designed to prevent spouses from benefiting from their non-arm’s length relationship by attributing for tax purposes any income or loss from property transferred to a spouse back to the transferring spouse.”
“to allow s. 74.1(1) to be used to reduce Mr. Lipson’s income tax from what it would have been without the transfer to his spouse would frustrate the purpose of the attribution rules.”
In analyzing misuse or abuse in respect of a series of transactions, the Court stated that the entire series should be considered. Individual transactions should be viewed in the context of the series. Moreover, the Court stated that the “overall purpose” of the series of transactions is not relevant at the misuse or abuse stage, as the taxpayer’s motivation is irrelevant. Rather, an “overall result” test more accurately reflects the wording of subsection 245(4). We will have to wait and see how the “overall result” test will play out in future GAAR cases.
One might ask whether the GAAR is still in fact a provision of last resort as a result of this decision. Although the Court in Lipson does state that the GAAR is a residual provision, Justice Lebel, for the majority, also writes in an apparent contradition, that: “the court should not refuse to apply it [the GAAR] 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.”
To counter the criticism that applying GAAR as it did in Lipson would introduce an unacceptable degree of uncertainty in tax planning, the Court responds that uncertainty is inherent in all tax planning situations. This may be true, but the question is one of degree. In our opinion, Lipson introduces a regrettable degree of uncertainty in tax planning. However, it seems that the fear of gutting the GAAR and the desire to give it a voice trumped over the goal of preserving predictability and certainty for taxpayers who have otherwise legitimately arranged their affairs to minimize tax.
Finally, it would appear, in light of the Court’s comments, that Singleton2, a prior Supreme Court decision with strikingly similar facts, would stand up to a GAAR challenge. Why doesn’t Lipson? As Justice Binnie states in his dissent, it is not clear why the additional reliance in Lipson on the attribution rules (“Singleton with a Spousal Twist”) suddenly becomes abusive tax avoidance. In his dissent, Justice Binnie disagrees with the majority view of what constitutes the object and spirit of section 74.1. As he states at paragraph 80 of the decision:
In an effort to identify the “object, spirit or purpose” of s. 74.1(1) abused by the appellant’s plan, my colleague LeBel J. states, as mentioned, that “the attribution rules in ss. 74.1 to 74.5 are anti-avoidance provisions whose purpose is to prevent spouses (and other related persons) from reducing tax by taking advantage of their non-arm’s length status when transferring property between themselves” (para. 32). In my respectful view, what LeBel J. believes s. 74.1(1) is designed to prevent is actually a reasonable statement of what s. 74.1(1) seeks to permit. This case, as my colleague appears to acknowledge at para. 32, is not about income splitting. The taxpayer’s evident purpose was to postpone capital gains tax on the transfer of property to the wife while in the meantime allowing any “income or loss[es]” to be attributed to himself. (emphasis added)
Identifying the object and spirit of a provision is an extremely complex and difficult exercise. The fact that Justice Binnie disagrees with the majority on the object and spirit of section 74.1 could arguably mean that there was doubt on this issue. If the existence of abusive tax avoidance is unclear, shouldn’t the benefit of the doubt be resolved in favour of the taxpayer? (Canada Trustco)
Justice Rothstein also dissented but for different reasons than Justice Binnie. According to Justice Rothstein, the Minister was precluded from reassessing the taxpayer on the basis of GAAR given that the GAAR is a measure of last resort (as an earlier Supreme Court decision on the GAAR – Canada Trustco – stated). Justice Rothstein believed that the Minister did have other recourse in this case given the provisions of ss. 74.5(11) (a specific anti-avoidance rule) which the Minister chose not to argue.
So, where are we with this important decision? To be honest, our firm’s thoughts are still being formed as to the consequences of this decision. Overall, our firm’s members are disappointed given that we had hoped that clarity regarding the application of the GAAR would be provided. Certainly, that is not the case. Notwithstanding, find below a partial and early list of some of the consequences, questions and comments that we believe may now be relevant:
- “Vanilla” interest deductibility planning should not be affected by this decision. Of course, it can be debated greatly what the definition of “vanilla” is.
- Are we now in a “substance over form” regime whereby the true substance of the legal transactions must now be considered in all cases as opposed to respecting the legal form?
- If a series of transactions are “smelly”, are they now subject to the GAAR?
- Given the fact that two members of the court were not a part of this decision (including Justice McLachlin who is a very senior tax justice) does this now mean that any hope for future clarity on the application of the GAAR is in the hands of the two remaining justices who did not hear this case?
- Will the dissenting judges’ voices eventually be heard?
- How will the “overall result” test play out in the application of GAAR cases?
- Is the GAAR still a provision of last resort?
- Are all tax planning strategies now subject to the new “overall result” test?
- It would appear that all tax planning strategies involving capital shifts in order to create or preserve interest deductibility may pose GAAR risk.
- Given that this is a huge win for the CRA, will the CRA now seek to invoke the GAAR on many other types of transactions where the overall first result is not in favor of the Crown?
- Given the overall result test, are specific statutory anti-avoidance provisions now needed?
- Is the effect of specific anti-avoidance rules now watered down if the GAAR can simply be applied without consideration of the specific rules?
- Is the long held principle that taxpayers may arrange their affairs in order to minimize their tax exposure now significantly in doubt? Many practitioners would certainly think so.
- As mentioned previously, the tax community was hoping for clarity with respect to the application of the GAAR. However, what appears to have emerged is a significant division of opinions in the Supreme Court of Canada and any clarity that was hoped for was certainly not achieved.
The above list is certainly not exhaustive and many excellent tax practitioners will be writing on this decision over the next days, months and years. We will continue to ponder the implications of this disappointing decision.
1. 2009 SCC 1.
2. The decision of Singleton (which was not decided on the basis of GAAR) found that interest deductibility was appropriate in a situation where a partner in a law firm extracted capital from a partnership, used the funds to purchase a house and then borrowed funds against his new house to replace the partnership capital.