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The Lipson Case Outcome and The Implication for the Smith Manoeuvre

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.

Facts

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:

  1. The Lipsons enter into an agreement to purchase a principal residence;
  2. Ms. Lipson obtains a bank loan for $562,500;
  3. Ms. Lipson used these loan proceeds to purchases shares owned by Mr. Lipson in the family investment corporation for $562,500;
  4. Mr. Lipson applies the $562,500 received in the share sale towards the purchase price of the home;
  5. 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.

Decision

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.).

Conclusions

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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{ 29 comments… add one }
  • DK January 29, 2009, 10:30 am

    Good summary.

    In my opinion, the “risk” of a SM mortgage is not an adverse court decision, although that exists too, the real risk is that the legislation can be amended at the drop of a hat to wipe out SM deductibility.

  • FT FrugalTrader January 29, 2009, 10:31 am

    Thanks for your interpretation of the Lipson outcome TMW. In my opinion, this is great news for people who use the plain jane Smith Manoeuvre strategy.

    DK, how would they legislate against the SM? They would have to ban the interest deduction on invested assets only which is unlikely in my opinion.

  • Rebecca January 29, 2009, 11:14 am

    Could someone please clarify the comment that “The ITA also allows interest to be deductible where it arises from refinancing, making step #5 deductible”?

    Is the refinancing process, itself a way to turn house equity into tax deductible amount or is the money from refinancing deductible only if it’s used to purchase other investments? The answer might be obvious, but I am not really familiar with different tax laws.

    Thanks,
    Rebecca

  • FT FrugalTrader January 29, 2009, 11:26 am

    Rebecca, I think what the article was trying to say was that if you refinance and use the proceeds to invest in income producing assets, then the interest will be tax deductible. It’s all in how you use the borrowed amount.

  • DK January 29, 2009, 11:55 am

    FT,

    What they would do is disallow the interest deductibility when the investment loan is secured against the taxpayer’s primary residence.

    I wouldn’t say it’s necessarily “likely” to happen, however keep in mind 3 things: 1) Parliament clearly intended that mortgage interest should not be deductible, 2) SM is a loophole and, 3) loopholes in the ITA tend to get plugged when they result in substantial loss of revenue for the Feds.

  • FT FrugalTrader January 29, 2009, 12:06 pm

    1. Is a home equity line of credit considered a mortgage? Isn’t it simply a line of credit “secured” against the equity of the home? If they didn’t intend mortgage interest to be deductible, then why can real estate investors claim the mortgage interest on investment properties?
    2. Why is SM a loophole? Aren’t investors simply leveraging?

    If they disallow using a line of credit to invest, then they’ll have to word it very clearly b/c that would mean that real estate investors and small business owners would also be affected.

    I realize what you’re saying is purely hypothetical, but I really don’t see how using a HELOC to invest is a tax loophole.

  • DK January 29, 2009, 12:30 pm

    The key thing to remember is that Canada could have followed the U.S. and allowed a mortgage on a principle residence to be deductible but they chose not to.

    And yes, when SM is used as a way of making your mortgage tax deductible (isn’t it touted as such?), then it is a loophole.

  • Xenko January 29, 2009, 12:45 pm

    “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.”

    I think the word you are looking for is wary.

  • Four Pillars January 29, 2009, 1:05 pm

    DK – I agree with FT – the “Smith Man”/”make your mortgage deductible” b.s. is just marketing smoke and mirrors created by opportunistic financial advisors.

    You aren’t really converting your mortgage to make it deductible at all. You are just paying down your regular mortgage and increasing your HELOC which are two separate events. This is not a loophole at all.

    As FT says – why would they outlaw a secured loan vs an unsecured loan to use as an investment loan? – that makes no sense at all.

  • DK January 29, 2009, 1:59 pm

    Then why the concern about audit risk and GAAR?

  • FT FrugalTrader January 29, 2009, 2:31 pm

    DK, the Lipson case is an example of how extreme tax measures can be challenged by CRA. I think the lesson is that he more aggressive you are with your tax planning, the higher the chance of audit. The singleton decision was not overturned, which means the SM in it’s plain form is safe.

    “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. “

  • DK January 29, 2009, 2:38 pm

    Right, I got that. I’m wondering why, if you don’t consider SM to be a loophole at all, 1) would there even be a concern that the SCC might overturn SM, and 2) why TMW calls it a “tax structure” containing an element of audit risk..

  • Les January 29, 2009, 2:41 pm

    I agree with Four Pillars. At the heart of it, the SM it is taking out a secured investment loan (secured against your house). The government would basically have to change the tax deductibility of investment loans or disallow deducting interest on interest for investment.

    The real risk of the SM is that you pick the wrong investments, especially if they eliminate or reduce dividends.

  • Elman January 29, 2009, 3:18 pm

    smith manuever is an old strategy repackaged as “make your mortgage deductable” . When my dad started his small business 30 years ago, he borrowed from the bank using the equity of our home. That loan was tax deductible.

  • jesse January 30, 2009, 1:44 am

    From the way I interpreted the decision, the court was showing how CRA must rule on similar cases. Given the complexity and specificity of the case, as mentioned above, the court basically told CRA that their laws need to establish intent and every subsequent ruling must do the same.

    The dissenters wanted to slap CRA harder on the wrist and have them tear down and re-write a poorly written and ambiguous set of tax laws.

    I would expect CRA to try to clarify its guidelines in the next 1-2 years but ultimately they’re trying to reconcile two opposing guidelines with the principal residency exemption on one side and CGT on the other. Can’t get around that easily and it could well be they will face listless legal cases from now on if they don’t do something about it.

  • Ed Rempel February 1, 2009, 2:57 pm

    Hi All,

    In case any of you saw the funny article in the Toronto Star by Bob Aaron, he is again 100% wrong! Here is his quote: “Earlier this month, the Supreme Court of Canada issued a decisive ruling that clarifies once and for all that the interest paid on a mortgage taken out to purchase a principal residence cannot be tax deductible under any circumstances.”

    Did he read the ruling at all? Funny, isn’t it?

    He quotes Dan White, who is obviously not a tax expert and does not appear to have any tax qualifications at all: “tax specialist Dan White wrote me to say that taxpayers simply “cannot convert their mortgage to tax-deductible interest.”

    For anyone that reads this article, Bob Aaron is a lawyer and supposedly professional, but obviously does not check his facts – or perhaps he knows he is wrong and has some reason for a bias.

    Dan White is flogging some strange tax scheme where, as I understand it, you create a series of sham buinesses to claim part of your home as tax deductible. After a year or 2, you shut it down and start another sham business. I read on the internet one of his clients recently lost a tax audit.

    There was another article last year by Bob Aaron quoting Dan White where they were also totally wrong. In that article, Dan White claimed that doing the SM would mean you are using your home as a business and will lose the prinipal residence deduction.” I have no idea where he gets this crap.

    In case anyone has any doubt, all the real tax experts, such as Jamie Golombek from CIBC Asset Management”, say the Supreme Court ruling finally clarifies that the SM, borrowing to invest in general and the Singleton Shuffle will not be questioned by CRA. The judges used the word “unimpeachable” when describing interest deductibility in a normal case of borrowing to invest.

    It bothers me to see such obviously wrong articles in major papers. The Toronto Star should cancel Bob Aaron as a columnist, since he seems to be biased, has printed 2 articles that are the completely wrong on tax issues, and he clearly does not check his facts.

    Ed

  • StellarGoods February 3, 2009, 7:24 pm

    Great posts Ed and FT.
    It always amazes me how often contributing business writers are wrong and have a weak understanding on matters on which they are supposed to bring expertise and insight.

    As poster Elman and FT mentioned, the SM is by no means a ”loophole” in the ITA; calling it as such is a misnomer. After having spent a considerable amount of time reading about the SM on this blog as well as on other sources on the net, I will summarize my understanding of this technique : a person starts off with a 20 year $100K mortgage. As our subject pays down his mortgage, he simultaneously draws down on a HELOC in equal amounts with his mortgage capital reimbursements in order to invest in an investment portfolio. In simple terms, fast-forward 20 years: the house is fully paid, mortgage is $0 however the HELOC would theoretically be $200K and in a perfect world, the underlying investment portfolio would be well in excess of $200K. Here’s my issue : assuming the HELOC has a rate of prime + 2%, for our subject to be in the money he would have to consistently generate pre-tax cash flows of an equal rate of return in order to break even. At no point in time, can anyone claim that the mortgage has been transformed into a deductible loan – you simply are using the equity in the home you are slowly building in order to bet on the stock market having an average return in excess of your HELOC rate. This is probably the blog that I read most often and that I enjoy most, therefore no disrespect to FT and other regulars, but I just can’t bring myself to accepting the marginal benefit that can be won in the face of the risks and stress from leveraging stock market positions (which can best be called ‘educated guesses’ in the short-term). I understand that the SM requires astutely picking strong dividend paying Canadian companies, but still, you can end up with the same mortgage plus a stock portfolio worth alot less that what you paid for plus incremental negative cash flows from the HELOC interest. Can anyone PLEASE provide with some insight because I must be missing something…

  • DAvid February 3, 2009, 8:54 pm

    StellarGoods said: ” “.

    Is there an echo here? The errors in this surmise were already addressed on this blog.

    DAvid

  • Andrew February 4, 2009, 11:11 am

    “The ITA also allows interest to be deductible where it arises from refinancing, making step #5 deductible”?

    My question is slightly different than Rebecca’s, or at least I think it is :-)

    Lets say I have a LOC at prime+1% with 30K in investments. Say I manage to get a HELOC at prime. Can I borrow 30K from the new lower interest HELOC to pay down the 30K, and still have the interest deducible going forward? I’m simply ‘refinancing’ the investment loan to a lower interest rate…

    I can see arguments on both sides, but its seems like a murky area and so far it just seems safer to leave it as it is.

  • Ed Rempel February 4, 2009, 10:50 pm

    Hi David,

    You’re right – Bob Aaron wrote a similar article last year where he also quoted Dan White and they were both 100% wrong then as well. I wrote to them, but no reponse. I think it is all a publicity stunt to promote Dan White’s wierd scheme and quite possibly they don’t even believe what they wrote.

    It is hard to understand when someone is so badly wrong.

    Ed

  • Ed Rempel February 4, 2009, 11:29 pm

    Hi Stellar,

    You may not be right for the SM. It is borrowing to invest, which is a higher risk strategy.

    It is kind of gimmicky, but is a bit more than just borrowing to invest. It is borrowing to invest by automatic monthly/bi-weekly purchase. It allows for dollar cost averaging and is an efficient way to get the maximum use from your home equity, since you can acceess each bit as soon as your regular mortgage payment makes it avaialble.

    What you are missing, though is:

    – The investments need to make more than the interest cost AFTER TAX IN THE LONG RUN, not CONSISTENTLY or in the SHORT TERM.

    Normally, the credit line is at prime which has averaged 4-5% in the last decade. If you are in a 42% tax bracket, the cost to you is between 2.4-3%. Your investments will need to make this amount after tax. Since capital gains and dividends are tax-preferred, your investments only need to make more than this for you to be ahead. If your investments long term make what the market has averaged, your long term returns are not “marginal”.

    If you eventually borrow 80% of your home value and it doubles a few times over a a few decades, the long term benefit can be surprisingly large.

    You are right that leveraging stock market positions is risky. The way to make this manageable is to invest long term and diversify well.

    Investing in dividend-paying stocks is only one option for the SM and is FT’s preferred investments. Dividends can result in little tax until you are 65, but leave you with a huge portion in Canadian banks and one or 2 other sectors in Canada.

    We usually use mutual funds managed by “All-star Fund Managers”. This way, we are far more diversified in all sectors and globally. We can automatically take out of the investments any amount you want to cover the interest and provide a retirement income for you.

    This way, there is normally little taxable income and it is usually only capital gains that are always tax-preferred – even after you retire.

    Ed

  • William February 9, 2009, 2:16 am

    Hi all,

    First of all I’d like to thank FrugalTrader for putting together this financial blog and everybody for contributing to it.

    I’d like to know if the interest on the investment loan use to fund the following 100% index portfolio can be tax deductible and if it would be a good investment for implementing the Smith Manoeuvre:

    Fund Name MER % Holding
    TD Canadian Index 0.31% 25%
    TD U.S. Index 0.33% 40%
    TD International Equity 0.48% 35%
    Total Portfolio 0.3775% 100%

    I’m considering converting a 7 year term @ 5.19% FirstLine mortgage to a Matrix Mortgage: LOC @ prime + 1.5% (I’m in the 2nd year of the term) Admin fee for this would be between $400.00 to $600.00
    Remaining amortization and time horizon is 20 years.

    Thanks again!

    William

  • FT FrugalTrader February 9, 2009, 8:57 am

    Hey William,

    I can’t comment on whether it’s a good idea or not, but your strategy to borrow to invest in equities will result in tax deductible interest.

    FT

  • Elbyron February 10, 2009, 9:14 pm

    My understanding of the judges decision is that they ruled against the Lipsons because they felt that their series of transactions violated the spirit of the attribution rules. They didn’t have any problem with how the Lipsons re-arranged ownership of assets in order to make the mortgage become tax deductible, right? So if Ms Lipson had been the one to declare the tax deduction, there wouldn’t have been a problem, because then they aren’t trying to abuse the attribution rules?

    This is important for me because I’m also trying to re-arrange ownership of a property in order to make its mortgage become tax-deductible. It’s currently my principal residence, and I plan to gift it to my fiancee for her to use (briefly) as her principal residence. She would then sell it back to me at fair market value, and I would buy it using a mortgage, with the intent of renting the property. In this manner, the mortgage loan is used to aquire a rental property, making it tax-deductible. The bank gives the cash to my fiancee, for her to use as down payment on our new principal residence.

    I’m not trying to abuse any tax laws, and I don’t think I’m violating the spirit of any of their rules. I consulted with a tax lawyer and he believes this is legit, based on the rulings in Singleton and Lipson. My only concern now is about possible attribution… which one of us should be declaring the rental income and the tax deductions? I wish I had asked the lawyer this question!

  • Ed Rempel February 12, 2010, 2:48 am

    Hi William,

    Investing borrowed money into almost any diversified equity investment is usually tax deductible. Your index funds are not what I would buy, but they should be deductible.

    Your mortgage is hugely expensive, though. 5.19%? We have only been that high once in the last 15 years. Find out what the penalty is to break it completely and get a new one. We are recommending 1-year fixed today and are getting rates as low as 1.99%. The credit line portion is prime +.5%. That could save you thousands.

    Are you using the mortgage for the SM, or are you just doing ordinary leverage with your investment loan?

    Ed

  • Ed Rempel February 12, 2010, 2:58 am

    Hi Elbyron,

    Sorry, but that looks questionable to me. If you just change the use of your principal residence to a rental property, your existing mortgage would become tax deductible. Your swap back and forth is an attempt to increase the mortgage to the current value of your home, but the actual purpose of the increased borrowing is to buy your new principal residence.

    Ed

  • Elbyron February 12, 2010, 4:09 pm

    Sorry, I neglected to mention that there was no current mortgage on the property. But in order to buy the new house, we needed the equity out of it. Unfortunately, simply taking out a new mortgage is basically the same thing as re-financing, and the direct use of the borrowed funds would be to purchase my new house, which is not a tax-deductible purpose. So, it is necessary to buy the condo using a new mortgage, then the direct use is to purchase an investment property. We ended up deciding not to do the “gift” portion of my plan, and just had my fiancee buy the property from me (she was not previously on title). I used the proceeds of the sale to buy the new house, and she took out a mortgage to buy the property from me. Thus she can now claim a deduction for the interest portion of the mortgage on the rental property. She also claims all the rental income, which in theory exceeds the expenses thus adding to her total income – and it’s better that she does this because although we currently earn similar salaries, she will eventually quit to raise a child, putting her into a lower tax bracket.

    The back and forth plan should have worked though, as the Singleton case proved that it is the direct use of the funds that determines deduction eligibility, regardless of what the overall purpose of the transactions are.

  • Ed Rempel February 12, 2010, 11:34 pm

    Hi All,

    If you want a good laugh, here is an update on Dan White, who wrongly criticized the SM in a Toronto Star article based on the Lipson case. See post 16 above.

    Here is a link to Jamie Golombek’s web site and an article about Dan White called “Dumb Write-offs”:

    http://www.jamiegolombek.com/printfriendly.php?article_id=916

    Read especially the tax deductions claimed in the last several paragraphs. :)

    Ed

  • William March 30, 2010, 3:39 pm

    Hi FT and Ed,
    Thanks for your comments on my request.

    I haven’t implemented the SM yet but I’ll be doing it in a couple of months.

    I’ve got a mortgage rate quote of 3.75% fixed for 5 years. With interest rates (assuming) going up in the near future, do you think this would be a good move? Ed, are you still recommending 1 year fixed term mortgage in this scenario?

    As my current mortgage is with FisrtLine and the penalty to go to another lender is huge I have to stick with the Matrix mortgage. My concern is regarding deductibility of the interest paid on the LOC portion of the Matrix mortgage. I understand the LOC is not reported to the credit bureau. Does this mean the LOC is part of the mortgage? For those who use the Matrix mortgage, do you receive a separate statement for the LOC portion of the Matrix mortgage? Can CRA claim I’m using money from my mortgage to invest and denied the interest deductibility of the LOC?

    I’m sorry for so many questions, I’d like to make sure I’ll do things right.

    Thanks a lot to everybody,

    William

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