Back in March 2008, Thicken My Wallet wrote a guest post “How Exposed is the Smith Manoeuvre to the Lipson Case?” Just recently, there was a verdict against the Lipson’s. The big question now is, how does it affect the Smith Manoeuvre?
Earlier this month, the Supreme Court of Canada issued its decision in the Lipson case, the much anticipated judgment on the General Anti-Avoidance Rule (the “GAAR”) of the Income Tax Act (Canada) (“ITA”) and tax structuring in general.
As a quick and dirty summary of the decision, it is a good news/bad news decision for taxpayers. The good news is that the Singleton decision, which is the fundamental legal basis for the Smith Manoeuvre (“SM”), was not over-turned. However, as I have written before, the case is not about the SM per se but about how aggressive a taxpayer can be in arranging its affairs to minimize taxes. On this end, the Court’s 4-3 decision, with two notable dissenting opinions, adds some uncertainty on this issue.
The Lipson engaged in a series of complicated commercial transactions which the Lipson’s argued would have allowed the interest on a mortgage registered on their principal residence to be deductible. In particular, the transaction consisted of the following steps:
- The Lipsons enter into an agreement to purchase a principal residence;
- Ms. Lipson obtains a bank loan for $562,500;
- Ms. Lipson used these loan proceeds to purchases shares owned by Mr. Lipson in the family investment corporation for $562,500;
- Mr. Lipson applies the $562,500 received in the share sale towards the purchase price of the home;
- A mortgage is immediately obtained for $562,500 which is used to pay off Ms. Lipson’s loan to the bank the day after the home is purchased.
The interest arising from step #3 is tax deductible since it falls within the section of the Income Tax Act which states that interest arising from “….borrowed money used for the purpose of earning income from a business or property…” is deductible. The ITA also allows interest to be deductible where it arises from refinancing, making step #5 deductible. The Supreme Court of Canada did not dispute any of these steps in isolation.
However, what the majority of the Court had an issue with what occurred next. When Mr. Lipson sold shares to Ms. Lipson, the ITA deems the sale to be at adjusted cost base and not fair market value (since they are spouses and eligible for tax deferral on a rollover basis). A transfer between spouses at adjusted cost base triggers the “attribution rules,” resulting in all the income and losses on the assets transferred (the shares in this case) being attributed to the transferor (Mr. Lipson) and not the transferee.
The attribution rules are a complex set of rules to ensure that transfer of assets between family members are not conducted below or above fair market value. The transferor spouse has the income attributed to them even after transfer. The end result being that CRA is no worse off after the transfer in terms of the amount of taxes collected from the family.
Since Ms. Lipson had to pay interest on the purchase of the shares, this interest deductibility is then attributed back to Mr. Lipson so he attempted to claim the deduction as the higher earning spouse. In other words, Mr. Lipson attempted to arrange his affairs such that he is not subject to capital gains on the sale of the shares and is also entitled to deduct the interest on his wife’s loan (although implicit in the decision is the fact that capital gains deferral was merely a side-benefit).
What the structure was attempting to do was to find a clever way to transfer interest deductibility to Mr. Lipson even though it was Ms. Lipson who took out the original investment loan.
Here is where the Court focuses on the majority of its analysis (and, as you can see, this is very far removed from a plain vanilla SM). Using an “overall result” approach, 4 members of the Court found that the transaction, as a whole, was abusive and the deductions denied under the GAAR. While each of the steps were, individually and in isolation, within the bounds of the law the Court found that the overall result was contrary to the ITA.
For lack of a better term, the transaction did not pass the smell test with the Court. The overall result approach relies on looking at any given transaction contextually, against the background of the policy for a particular tax rule, and determining whether the transaction is abusive. It is, as you can well imagine, very much an approach based on the equities of the case rather than a more black and white approach.
Adding to this uncertainty is two different dissenting opinions; one dissenting opinion by 2 judges argued that the object and spirit of the attribution rules were not violated and that the majority’s decision, relying on an overall result approach, would lead to unpredictability in how a taxpayer arranged its affairs.
The second, more technical, dissenting opinion argued that the GAAR should have never applied since there was already a specific attribution rule which Canada Revenue Agency should have attempted to apply. This opinion chided Canada Revenue Agency for throwing the kitchen sink (GAAR) before actually applying the specific provision and trying to get the Court to do its work (typically, in law, you apply a specific provision before referencing a general provision and not the other way around.).
Tax cases are very much fact driven. Thus, it is difficult to say how this decision applies to any one person’s tax planning.
Having said that, what has survived scrutiny from this decision is that a taxpayer can structure their financings to be tax efficient. As summarized above, any of the transactions above, in isolation, fell within four corners of the law. The Lipson case has never been about the SM per se.
Instead, it has been about how far a taxpayer can take its tax planning and where tax structures, like the SM, meet the GAAR. On this issue, the Court has rendered a large “it depends” and “we know when it is abusive when we see it” decision. This type of uncertainty favors Canada Revenue Agency since most taxpayers do not have the resources to litigate an “it depends” situation to Tax Court.
SM’s, like any tax structuring, will always contain some element of audit risk. The question always is how much. This is an assessment best made by looking at the whole of the transaction with a professional. In light of Lipson, the more aggressive the approach, the more weary a taxpayer should be of the application of the GAAR to deny deductibility.
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.
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