My grandfather used to tell me that if I was going to borrow money, I should borrow from a pessimist. The reason is simple: They never expect to get it back. As good as that advice might be, my grandfather never did explain how to reduce the cost of borrowing. Claiming a deduction for your interest costs will do that. On that subject, there's a lesson to be learned from a decision handed down by the Supreme Court of Canada last week in the case of Lipson v. Canada. Let me explain.
THE CASE
In this case, Mrs. Lipson borrowed about $560,000 from the bank and used the funds to purchase shares from her husband in a private company that he owned. Now, since she was borrowing to purchase shares, she was entitled to a deduction for her loan interest. Next, Mr. Lipson used the $560,000 to purchase a home for the couple. Immediately after purchasing the home, Mr. and Mrs. Lipson borrowed another $560,000 secured by the home, and paid back the original loan that had been taken out by Mrs. Lipson.
What about the tax law? First, under paragraph 20(1)(c) of Canadian tax law, Mrs. Lipson was entitled to a deduction for her interest costs since she had used the borrowed money for an income-producing purpose. Second, when that loan was paid off, the interest on the replacement loan was also deductible since subsection 20(3) of our tax law allows this when the interest had been deductible on the original loan. So far, so good.
Third, there was no tax on the sale of the shares by Mr. Lipson to Mrs. Lipson. You see, transfers between spouses are always deemed to have taken place at adjusted cost base, not fair market value, unless you elect otherwise. Mr. Lipson did not opt out of subsection 73(1) of our tax law, and therefore the sale took place at his adjusted cost base, and no tax was owing.
Finally, when assets are transferred between spouses at adjusted cost base instead of fair market value, the attribution rules (section 74.1 of our tax law) will apply so that all income and losses on the assets (the shares transferred to Mrs. Lipson in this case) will be attributed back to the transferor (Mr. Lipson).
The bottom line? The interest costs paid by Mrs. Lipson, which represented a loss to her, were attributed back to Mr. Lipson. That's right, Mr. Lipson claimed the deduction, not Mrs. Lipson. The court didn't appreciate this last result.
THE DECISION
The majority of Supreme Court justices (four to three) ruled in favour of the tax collector and applied the general anti-avoidance rule (GAAR) to deny Mr. Lipson his interest deduction. Now, the Lipsons used four separate provisions of our tax law, and did not violate any of them. If you look at each step in the series of transactions, everything worked according to the tax law. The Supreme Court decided, however, that it's important to look at the results that occur when piecing together a series of steps to determine if those results run contrary to the intention of the tax law. That is, to determine if there was a misuse or abuse of the tax law. In this case, they concluded this was the case.
THE MORAL
What does this mean for Canadian taxpayers? Let me note a couple of things.
First, there's going to be some uncertainty for taxpayers going forward about whether a particular strategy will work if it's not clear whether the results are considered "abusive." The court simply notes: "To the extent that it may not always be obvious whether the purpose of a provision is frustrated by an avoidance transaction, the GAAR may introduce a degree of uncertainty into tax planning, but such uncertainty is inherent in all situations in which the law must be applied to unique facts." In other words, "tough luck." We're going to have to live with some uncertainty.
Next, there is some good news. The court did confirm that GAAR should not generally apply when taxpayers rearrange their borrowings to minimize their taxes. In the Lipson case, the court was fine with the interest deduction itself, but took offence to Mr. Lipson claiming the deduction by relying on the attribution rules to give him the deduction (he was the higher-income spouse, and therefore benefited more from the interest deduction). And so, we should spend some time looking at ways to arrange debt to make the interest deductible. Let's start that next week.
Tim Cestnick