Lisa Philipps is a professor at York University's Osgoode Hall Law School, where she teaches tax law and policy.
The Panama Papers have refocused attention on how Canada can protect its tax base in a world of mobile capital and abundant tax planning. Who is responsible for closing the legal loopholes that enable tax avoidance? The essential role of the courts is often overlooked.
Stopping outright evasion is a job for revenue authorities and police. Those who hide money from the tax collector risk steep fines, prison time and the stigma of criminal conviction. But many avoidance schemes are legal – a more serious problem as it calls into question the system's basic fairness. If tax laws can be circumvented by those with access to high-end advice, perhaps the ground rules of our market economy really are rigged in favour of a privileged few.
Tax laws are designed by experts in the Department of Finance, drafted with the help of Justice officials, passed by Parliament and administered by Canada Revenue Agency. All strive to protect the tax system's integrity, but their capacity to prevent tax avoidance is inherently limited. It is not humanly possible for those who write the law to anticipate all future ways that people will attempt to skirt the rules. Inevitably, some taxpayers will claim that the law technically does not catch them because they have used creative legal structures, perhaps including an offshore company or trust.
Revenue authorities can and do challenge these schemes in court. But, ultimately, we must rely on judges to look through the verbiage and uphold the spirit of the law. This will require a shift in judicial philosophy. With some exceptions, Canadian judges have defaulted to a literal reading of tax law that is based on 19th-century English precedents. This approach stresses, above all, the right of property owners to rearrange their affairs to minimize tax.
In the United States, the courts took a different tack, ignoring transactions that were designed purely to escape tax. By the 1970s, the English judiciary was also moving in this direction. In a series of landmark cases, they recognized that taxpayer liberty must be balanced with the need to distribute the cost of government services fairly, according to Parliament's intentions. Canadian courts have been slower to leave 19th-century England behind.
Frustrated by our judiciary's passive approach, the government added a general anti-avoidance rule to the Income Tax Act in 1988. The rule gives judges explicit authority to override tax planning that abuses the law by defeating its purpose. Yet, in many cases, our courts are hesitant to follow through.
To provide one example, everyone knows that interest on a home mortgage cannot be deducted for tax purposes. Except that individuals with liquid wealth have figured out a way around this. The first step is to cash out some investments, say stocks and bonds, and use the proceeds to pay for a new house. Later on the same day, the investor obtains a bank loan secured on the new home and uses the borrowed money to repurchase the same stocks and bonds. This way, it is possible to argue that the purpose of the loan was to invest in income-generating securities, for which interest is deductible.
It is transparently obvious that the real purpose of these transactions is to obtain a mortgage to finance a home purchase. The individual holds the same portfolio of investments before and after. Yet, to the surprise of many tax professionals, the Supreme Court of Canada endorsed this device in a 2001 case called Singleton. In doing so, it overturned older decisions that had rejected such planning as artificial and unfair to all those without financial assets, who get no deduction for their mortgage payments.
Such rulings bear a share of the responsibility for eroding the integrity and fairness of Canada's tax system. They signal that tax planners can be aggressive in pushing the limits of the law, creating a thriving market for new avoidance ideas. As soon as one implausible story succeeds, the race is on to manufacture more. Authorities struggle to keep up and understandably wonder whether it is wise to invest their limited resources to challenge these ventures in court. Rewriting the tax law to close technical loopholes must be done carefully. By the time it is done, tax planners have already moved on to the next gambit. It is easy to point the finger at lawyers and accountants as enablers. It is true that these professionals make a handsome living from helping their clients to reduce tax bills. Some will admit privately their discomfort with deals that seem to make a mockery of the progressive income tax. But, in most cases, they are only doing what the courts have licensed. Until the judiciary also sends a stronger message, we can expect a culture of aggressive planning to persist.