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How Exposed is the Smith Manoeuvre to the Lipson Case?

Written by FrugalTrader on Mar 19, 2008 filed under Smith Manoeuvre

Numerous readers have contacted me regarding the current Lipson case and it's potential affect on the Smith Manoeuvre. When it comes to legal matters, I usually contact a lawyer for more information. It just so happens that the blogger behind Thicken My Wallet is a former lawyer and is more than willing to help. Below are his thoughts on the Lipson case. A warning though, the article is a bit long but an essential read for those considering the SM.

MDJ has asked me to guest-post on the legal risks of the Smith Maneuver (the “SM”) as it related to the Lipson Case which is now being heard by the Supreme Court of Canada. The Lipson case has thrown considerable confusion into the ability of the SM to with-stand audit scrutiny.

I have summarized the Lipson case thus far and provided some comments and observations. If you are looking for particular legal advice on this case then I will be up-front and say no one, including me, can provide advice on this matter given the Supreme Court of Canada has yet to render a decision on the appeal.

Having said that, I wanted to take this opportunity to try to cut through the noise of the Lipson case and take a look at the SM more contextually (wish me luck).

For definitional purposes, I use the term “SM” to describe any type of transaction whereby the interest on mortgage payments on a principal residence are claimed as deductions (there are various variations of the SM and not just one involving converting an existing mortgage to a HELOC to purchase securities or investment real estate).

The Facts

The Lipon’s engaged in a series of transactions as follows:

Earl and Jordanna Lipson bought a home in Forest Hill in Toronto;
Ms. Lipson obtained a $562,500 loan NOT to buy the house but for Ms. Lipson to buy shares in Mr. Lipsons private held corporation;
Mr. Lipson then used the $562,500 of funds invested by Ms. Lipson to purchase the home;
A mortgage for $562,500 is obtained which is then used to repay Ms. Lipson’s $562,500 loan referenced in step #2.

In and of itself, since step #2 involved “….borrowed money used for the purpose of earning income from a business or property…”, the interest payable is fully tax deductible.

Step #4, in isolation, involved interest paid on refinancing which, under section 20(3) of the Income Tax Act (Canada), allowed the interest from this loan to also be fully tax deductible.

Why the Interest Deduction was Denied

The deductibility of the interest payments was denied by CRA under what I like to call CRA’s kitchen sink defense (when all else fails, throw the kitchen sink at it): the general anti-avoidance rules (GAAR) of the Income Tax Act which allows CRA to deny a deduction if there is “misuse or abuse” of the tax rules.

The Courts agreed that GAAR could be invoked to deny what was otherwise a series of tax planning steps which fell well within the rules of deductibility but, as a whole, the transaction was a misuse or abuse of the rules.

Of significance, Justice Bowman, the trail judge, placed great weight on the fact the overall purpose of the series of transaction was “to make interest on money used to buy a personal residence deductible” which, under our tax laws, cannot be deductible but for some type of supportable tax transaction(s) (it is the exact opposite in the U.S. where interest is deductible).

Observations on the Court Decisions

There are several observations which can be made out of the decisions thus far.

The Lipson case, thus far, does NOT over-turn the Singleton case and the deductibility of interest from borrowed money used for earning income through business/investments etc. The case instead addresses how far is too far for this type of transaction. They are two fundamentally different issues- the concept of the SM has not been over-turned. The question is how far can someone take it (which is the essence of any case involving GAAR)?
The Lipson conceded at trial that there was a tax benefit and, more importantly, the transaction was an “avoidance transaction” under the tax rules. It is a really poor analogy but, in plain English, it was tantamount to admitting guilt in a criminal trial but arguing the cops investigated you unconstitutionally so you should get off. Reading between the lines, and this is my opinion alone, the Lipson’s lawyers made the calculation that the Courts would be loathe to hand CRA carte blanche over when they could invoke GAAR and assumed the Courts would rein in the power of the state. I suspect this calculation was influenced in part by several losses CRA suffered over GAAR and SM before this trial. Critics of the decision have indicated that Justice Bowman went against recent case law on the matter which sided with tax-payers. The question becomes will the Supreme Court of Canada agree with Justice Bowman and rule that people have taken a good thing too far?
The Lipson’s, in the eyes of the Court, were aggressive in their tax planning. There was not an attempt to structure their transaction as estate planning or commercial tax structure (examples Justice Bowman gave where the deductibility of interest would have been generally supportable in his eyes). There has been some criticism in some legal circles that Justice Bowman’s decision was merely a “smell test” and did not contain sufficient legal direction (which may explain why the Supreme Court of Canada is hearing the appeal). This is now in the hands of the Supreme Court of Canada to decide.

Supreme Court of Canada (“SCC”) Appeal

The SCC has granted leave to hear the Lipson’s appeal with the hearing scheduled for April 23, 2008 (which likely means a decision sometime in the late summer/early fall of 2008 based on the Court’s work rate).

This appeal is purely on an appeal based on errors of the law. The summary of issues can be found here.

Again, please note that the issue is whether the transaction constitutes an “abuse” of SM and not a challenge to SM itself. I am not going to remotely guess what the Court will decide other than to reiterate that the SCC will be not be asked to overturn SM (although judicial discretion does allow the SCC to address this issue).

A Few Final Thoughts

The Singleton case (which was the seminal decisions upholding the deductibility of interest in a SM type of structure) has analogous fact scenario but GAAR was never raised as a defense. It merely looked at whether the series of transactions were within the tax rules.
Whenever a particular tax structure goes mainstream, and is no longer the sole domain of the rich, CRA attempts to shut down the structure all together. A recent example of this is their high profile crack-down on tax shelters and Minister of Finance musing about scrutinizing Canadians with off-shore bank accounts. This may be the latest example of this pattern. SM, in essence, got too popular for its own good and, regardless of the decision, CRA may begin to scrutinize all SM’s with a greater frequency since the SCC will most likely give some clarity on when and where the CRA may challenge the SM using GAAR and, donuts to dollars, CRA will use this to their advantage (after all, the economy is slowing down and CRA will need to find sources of tax revenue elsewhere).
Thus, for those wondering whether they should attempt a SM, here is your worse case scenario: CRA is given sufficient guidance by the SCC to deny variations of the SM under GAAR. Thus, the question becomes, if interest deductibility is denied, is the profit on business income greater than the cost (i.e. interest payments) of obtaining borrowed money? If profits are being created now purely because interest can be deducted under a SM (i.e. your profit is purely tax-driven and not due to any particular investing acumen), one’s exposure is higher than if profits are made regardless of deductibility since if the SM does not survive audit scrutiny, one may be in a negative cash flow position.

I apologize for the long post (it’s the lawyer in me) but the essential question you should ask yourself with your professional team (and, please, a SM is not a DIY exercise) is:

Do I have the investing skill to make more money on my investments than the interest I have to pay on a HELOC even if the interest is not tax deductible?

If the answer is yes, then the decision is really yours to make as to whether you have the risk tolerance to undertake quite a complicated structure. If the answer is no, and the profits are made purely for tax write-offs, please consult with your professionals for sober second (and third) opinions. Any type of business/investment which relies upon tax deductions alone to turn a profit should be avoided since the certainty of those deductions cannot be guaranteed.

Is it just HELOC or bust?

I would like to mention, as a side-note, that leveraging the equity in one home is not the only option to obtain borrowed money where interest is deductible. A secured line of credit can be obtained if one has sufficient assets (I know my bank will grant me a secured LOC greater than $50,000). Since most people’s biggest asset is their principal residence, the principal residence is, indirectly, being used as collateral for that loan. In essence, it is no different than what some day-traders did earlier this decade- put up a personal guarantee in order to access funds to trade on the market.

Since the security on a secured LOC is being registered in the personal property registry, and not as a mortgage against title, it removes some of the audit scrutiny issues raised in the Lipson case since the interest on mortgage payments is not being deducted but the interest on the LOC is. This type of financing does not give to you the quantum of funds a HELOC does but removes the fundamental objection of CRA in the Lipson case. Yes, you cannot claim interest deductions on your mortgage but will you sleep better at night trading off the loss of deductions with a smaller chance of audit scrutiny?

The reason why it is not pushed much is because mortgage brokers do not make money off of it so there is no industry gain to pushing this. However, this type of structure does not fundamentally change the issue of whether on has sufficient risk tolerance and investment acumen to undertake any leveraging to invest. Again, please seek professional advise about this type of structure.

For those who are on the fence about SM, I have posted on taking a more contextual approach to this issue before.

Think carefully about a SM. Removing even the uncertainty of the Lipson case, it is a complicated structure to arrange and please do seek qualified professional advice on this matter.

This post is for informational purposes only and should not constitute advice of any kind whatsoever. Please consult your lawyer and accountant if you wish to seek advice on this or any tax-related matters.

14 Comments, Comment or Ping

1. The Financial Blogger

In the end, if you keep all your transactions simple (ie. withdraw money from a HELOC and buy invest with it), you should not have any problem.

When it starts to get complicated, the GAAR will come into play and then, we are not sure of anything. KISS is the best advice possible when you are dealing with the government ;-)

Mar 19th, 2008 @ 7:53 am
2. FourPillars

I’m not a lawyer and I’m nowhere near as smart as TMW but I still have to disagree with his extremely conservative position on the SM.

I realize there are extra “twists” on the SM which I suppose could be disallowed in the future, but the main aspect of the SM is really leveraged investing - regardless of how your financial advisor dresses it up to be something different.

TMW says that the SM involves deducting interest on mortgage payments which is not what the SM or leveraged investing using a HELOC is.

I also don’t see what difference it makes where you borrow the money - if you have a HELOC and pay interest on the HELOC then that is totally separate from your mortgage payments (as I understand it anyways). Using an unsecured LOC or margin loan is a more expensive option and I think you are paying extra interest for nothing.

Like FB said - keep is simple and stay away from the “maximums” etc and you have nothing to worry about.

Mike

Mar 19th, 2008 @ 10:24 am
3. David

I enjoyed this post. I am not suggesting that FB is wrong about KISS, but I’m not certain he/she is right either. As I’ve stated, and I’m likely going to do a variation of the SM when I buy my first house, I’m concerned that since GAAR was not argued in Singelton, the SCC may say that 20 (1)(c) is only applicable for active business income, not passive. Which would mean ALL investing would be denied tax deductible status.

I know that I pay taxes on the income I make from investments right now, but that income is not applicable when determining my RRSP limits. So the CRA already makes distinctions upon the source of the income (passive versus employment in my case).

Assuming Lipson somehow ‘outlaws’ SM, you’d still have a mortgage that you can pay. So in that situation you’re not in terrible shape. But, people are paying hefty fees and higher mortgage rates in an attempt to run a SM, so you have to be careful.

That said, I’m not offering advice and I don’t really know what I’m talking about. I do understand that the Supreme Court doesn’t take cases so they can say that one person was wrong, they take cases so that they can make broad statements. My guess is that whatever the decision in Lipson is, it will become clear whether the SM works in ALL situations or none. I don’t see much of a middle ground.

Mar 19th, 2008 @ 10:30 am
4. FourPillars

I just don’t see the connection between the Lipson case and leveraged investing.

With leveraged investing you borrow money to invest and deduct the interest on the investment loan.

The Lipson’s are literally deducting the interest paid on their principal home mortgage by some accounting slight-of-hand which in my mind is not the same as deducting interest on a leverage loan.

Am I missing something?

Mar 19th, 2008 @ 11:29 am
5. Daniel

I used ManulifeOne product which is a credit line against my house. The money use for investing is well defined and separate but it all comes out of one account.

I would find it difficult for the CRA to deny my deductions for investing because the money comes out from the same account that I use to buy milk and beer. It would have to become where they deny all deductions on interest for investing.

That’s just my 2 cents.

Mar 19th, 2008 @ 11:52 am
6. nobleea

It seems to me the Lipson case was more about a financial transaction that was not arms length with the sole purpose of writing off their mortgage interest. The CRA would not take kindly to that, and I don’t think many tax payers would either.

Mar 19th, 2008 @ 12:30 pm
7. DAvid

TMW said: “For definitional purposes, I use the term “SM” to describe any type of transaction whereby the interest on mortgage payments on a principal residence are claimed as deductions”

This of course is not Fraser Smith’s definition of the Smith Manoeuvre. Were you to engage in a practice as defined by TMW, then you might well be far more open to audit than by engaging in the real SM. The Smith Manoeuvre is the use of the increasing equity in your home to back a loan allowing you to incrementally purchase an investment portfolio by dollar cost averaging, while claiming deduction on the investment loan interest. The interest on the mortgage payments is not claimed as a tax deduction. The SM is also not limited to your principal residence, though most folks start with that resource.

DAvid

Mar 19th, 2008 @ 12:31 pm
8. Chuck

I think the most misunderstood part of the smith maneuvre is that its not making your mortgage interest tax deductable as all the financial planners like to advertise. Its really an investment loan that you collateralize against your home in order to get a lower interest rate.

So yes this case is a flagrant attempt to do an end run around the ITA. Whereas the SM is really just an investment loan.

-Charles

Mar 19th, 2008 @ 12:40 pm
9. The Reverend

I absolutely, 100% agree with Chuck, and wish this was clarified more often.

Smith Maneuvre is not making your mortgage interest tax deductible. Its a cheaper investment loan that you’d be able to get if it wasn’t otherwise secured with your house as collateral.

I use the word cheap loosely as its hard to say what the cost of having your own home as collateral for a loan versus not having any collateral at all.

The marketing of SM drives me bonkers. As well as the whole, “your investments only have to outperform the interest paid less tax deductions” comments. This glazes over the fact that you are taxed on your investment income as well.

Its a cheap investment loan, plain and simple.

Mar 19th, 2008 @ 1:53 pm
10. thickenmywallet

Thanks for posting this FT and thanks for the great comments.

For clarity, just a few comments

- as several readers alluded to, and as I wrote, the question is how much is too much in a SM? The SCC is most likely not going to “outlaw” SM. It could rein it in considerably.

- I thought David’s comment of passive vs. active income is an extremely thought-provoking issue that has not been argued as of yet (hmmm… David, you may just given CRA an idea!)

- I reiterate my original point that while my post starts as a legal post, the key question is do you have enough skill to ensure you can make money regardless of any tax write-offs. Four Pillars is right- I am extremely conservative about SM because, statistically speaking, most “average” investor struggles to beat inflation investing in stocks and less than half of American real estate investors surveyed indicated they knew with certainty, they were making money (my source is Retire Rich from Real Estate by Marc Andersen and the survey was taken before the crash). If you have the skill and risk tolerance to undertake this structure, I would suggest you guest post on MDJ and share your insight with us but I would be interested to know how you did it!

Mar 19th, 2008 @ 2:02 pm
11. falconaire@sympatico.ca: Sandor

Dear thicken,

I am grateful that you made such thorough analysis of the Lipson’s trick, but I think, (it is more like a feeling then an argument) that step #4 shouldn’t be deductible in any case.
The money was used to repay a personal loan. I hate to admit it, but I understand the CRA’s refusal in light of the Singleton and the Ludco case.
It won’t surprise me if the Court disallows it.
In fact, if I were the advisor dealing with this case, I would have pointed out to them that the steps here are the inversion of the SM and what they are doing is going from a tax-deductible case towards a non-taxdeductible mortgage.
They were not only too “clever” for their own good, but also lost their sense of reason and propriety.
Also, a simpler, but more concentrated plan would have served their purpose better.
I think they are toast.
However, I don’t feel any threat to the SM. (Well not much anyway) A properly invested LOC is what most businesses use, and just because the borrower is not a business but a natural person, there is simply no excuse to disallow the strategy.
I also have some doubt about the success of the investments as a condition for the deductibility. If that would be required, then every business that uses borrowed money should have to be examined every year, wether they made money, or not, and if they didn’t, their tax would rise by the amount that would have been a tax deduction in a profitable year. This doesn’t seem reasonable.
I don’t believe that the provision of “reasonable expectation of making an income” will be done away with.

Mar 21st, 2008 @ 4:58 pm
12. Kris B

Very interesting, and worrying conversation here. As a homeowner with a M1 account used for SM, I will have to follow these proceedings. Is there any indication on a timeline for a decision?

Any comments from others on the best ways to focus your investments if this case does sort out in a “worst-case” scenario for SM? I.e. real-estate investments vs. mutual funds, or fixed income.

Apr 14th, 2008 @ 1:24 am
13. eb

Accounting student who should be studying for his tax exam here…

Here’s my take:
Under SM, interest is being paid out twice - once for the mortgage and once for the loan. The equity in the house is merely used to secure the loan, but the mortgage is interest is not deducted. The interest paid on the LOC (backed by the house), is deducted. However, since that LOC is used to buy investments, it should be tax deductible.

The Lipson’s did not break any laws in the ITA doing what they did. But it’s evident that the moves they made allowed them to make a personal loan (mortgage), tax deductible. They’re only paying interest once (loan to pay back the original loan), but in the end they have a house that is mortgaged.

SM and Lipson seem to be very different to me.

The (poor) taxpayer in me hopes the CRA wins this one.

Apr 14th, 2008 @ 3:28 am
14. Joe Gasparini

Well it doesn’t surprise me that the CRA is after the little guy once again. Go after the big cheaters and leave us alone. I am in the process of implementing the SM and I will be changing over to the Royal Bank in order to make the process easier. I have an advisor and an CA to ensure it is legal. My goal is to have my Mortgage transfered to my HLOC asap. Over the last 10 years my RRSPs have peformed quite well except the past year. I have a good solid income that is recession proof and a solid pension. The Lord hates a coward and I am tired of the interest being paid on my mortgage. So it is time to act and implement the SM. Good Luck to all who use this innovated investment opportunity.

May 8th, 2008 @ 11:16 pm