Canada: Supreme Court Of Canada To Hear Tax Avoidance Case

Next Wednesday, April 23, the Supreme Court will hear a case involving Canada's "General Anti-Avoidance Rule", which could substantially clarify the latitude that Canadians have to tax plan, as well as resolve related issues pertaining to Canada's restrictive and rigid rules for deducting interest on borrowed funds. This matter is previewed in the article (below):

Lipson Hearing More Than Simple Tax Arbitrage
(as written by Nathan Boidman and published in the National Post, Financial Post)

April 16, 2008

In the April 2 Legal Post, Vern Krishna carefully explained the contest and conflict the Supreme Court will hear on April 23, between "legitimate tax planning" and "abusive tax planning" in the Lipson case.

This is where Mrs. Lipson borrowed money to buy common shares of a profitable family holding company from her husband, Mr. Lipson, and then both used the cash (paid by her to him) to jointly buy a home, with the couple giving the lending bank security for a replacement loan to Mrs. Lipson, by way of a mortgage interest in the jointly-owned home.

The Supreme Court must decide whether those transactions — viewed in the light of rigid rules for deducting, interest expense on borrowed funds, coupled with separate mechanical rules that govern transactions between spouses — properly gave Mr. Lipson a deduction in his tax return for any excess of the interest Mrs. Lipson would pay to the lending bank over dividends she would receive on the shares that she purchased. Or did they constitute "abusive tax avoidance" within the meaning of Canada's statutory "General Anti-Avoidance Rule" (GAAR)?

The concern is that Mr. Krishna's piece, which characterized the overall arrangement as one that was "intended to arbitrage what would have been non-deductible interest on their home mortgage into deductible interest for tax purposes" provided a somewhat jaundiced view of the matter.

It's a view that could inappropriately prejudice the manner in which the Supreme Court views the issue and adversely affect the interests of both the Lipsons and Canadian taxpayers generally.

There are three distinct reasons for this concern. First, a review of the business, property rights and commercial effects of what transpired reflect a substantially different perspective than that suggested by Mr. Krishna.

Before the arrangement, Mr. Lipson owned all of the shares of his profitable Canadian company, the couple did not own a home and had no debt.

After the arrangement, Mrs. Lipson had an income-producing asset, in the form of common shares of a profitable Canadian company. She, not Mr. Lipson, would enjoy dividends on those shares. She, not Mr. Lipson, would enjoy the benefit of future appreciation in the value of those shares. If the couple divorced and Mrs. Lipson subsequently sold the shares for millions of dollars, she, not he, would benefit from and retain and own those proceeds.

Seen in that factual light, the interest paid by Mrs. Lipson was clearly applicable to the financing of the shares.

It is important to note the form employed by the lending bank in taking its security for the loan to Mrs. Lipson, in the jointly owned home a "joint loan" to the two of them rather than a loan to Mrs. Lipson alone guaranteed by Mr. Lipson is seen every day in commercial and corporate finance circles, where, for example, a subsidiary corporation wants to borrow to finance its operations with a guarantee of the borrowings by its parent.

Second, Mr. Krishna carefully points out the mechanical and sometimes arbitrary manner in which the thousands of Canadian tax rules operate and that Canadian law respects and requires compliance with the legal form of transactions. But this is a two-edged sword. For example, when a Canadian multi-national enters into a purely internal reorganization, which truly affects nobody's interests — unlike in Lipson — these two factors serve to impose a tax on that internal reorganization — with no economic effect — unless highly complex "exceptions", such as rollover rules, apply and are followed.

In that context, why, when these arbitrary rules and somewhat mechanical principles go the other way and see a taxpayer — such as the Lipsons, where there were true changes of economic position — save tax as opposed to paying tax on phantom artificial gains should the Canadian government complain?

Third, the piece points out that the Supreme Court's first decision on GAAR in October 2005 identified the 73-year old principle established by the House of Lords in 1935 in the Duke of Westminster case that, in the words of Mr. Krishna, "a taxpayer can legally arrange his affairs to minimize the tax payable regardless of his motive. The principle is simply one aspect of the doctrine, that taxpayers should be governed by the rule of law, preferably clear and certain laws. "

However, the very essence of tax planning is carrying out a transaction in a way that takes tax rules into account and crafts the arrangement to arrive at a reduction of tax. If the Duke of Westminster principle is to be given meaning and not be emasculated by the opposing notion of "abusive tax avoidance", it would seem to necessarily apply where the arrangement entails a significant change of economic position as in Lipson, and is not a sham-like, closed-loop, series of transactions, with no effect of an economic nature whatever, as was identified in the famous 1984 House of Lords decision in Furniss (Inspector of Taxes) v. Dawson, as "self-cancelling" transactions.

At the end of the day the direct question raised in Lipson is whether, as suggested in Mr. Krishna's piece, the arrangement was tainted by abusive tax avoidance or, as suggested above, a sufficiently robust, tax-planned arrangement with substantial economic effect, so as to qualify for the 1935 doctrine of the House of Lords in the Duke of Westminster? The more fundamental issue raised is the extent to which Canadians can have certainty and predictability in arranging their borrowings and affairs to come within the rules for the deductibility of interest expense. We will know soon enough.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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