Happy Is as Happy Does: Mortgage Interest Deductibility & the GAAR
Happy Is as Happy Does: Mortgage Interest Deductibility & the GAAR (Tuesday, February 19, 2008 ) - Nicole Ewing
Happy and Snitty are soon-to-be neighbours. Snitty shops around for a mortgage, haggles over half a percentage point, and ultimately accepts the financing offered by the institution he’s banked with for years. He purchases a home with the funds and makes the first of many mortgage payments, knowing a large portion of each payment will go toward the interest, and not the principal amount, of his loan.
Happy, on the other hand, knows that with just a couple of extra steps, the interest payments he makes on the funds that permit him to purchase a home will be tax-deductible. You see, Happy has an investment portfolio with significant holdings. Happy sells his investments, applies the proceeds toward his new home, and then borrows money and repurchases the investments – ta dum – the interest on his loan will be deductible.
Or will it?
Deductibility of Interest
Interest on borrowed money is deductible if the money is used for the purpose of earning income from a business or property. Tax planners have long sought to implement strategies that would convert otherwise non-deductible interest into deductible interest, and have done so with the blessing of the Supreme Court of Canada. In Singleton v. The Queen, the Supreme Court considered a scenario where a taxpayer – a member of a professional partnership – withdrew money from his partnership capital account, used the funds to purchase a home, and then used borrowed money to replace the withdrawn capital. The Supreme Court held that the transaction met the income-earning purpose test for the deduction of interest and the deduction was allowed.
But the Federal Court of Appeal’s 2007 decision in Lipson v. The Queen has thrown these Singleton-type strategies into question. The Supreme Court of Canada is scheduled to hear an appeal of the decision on April 23, 2008 and the Court’s ruling will determine whether tax planners need to reconsider some long-standing interest deductibility arrangements.
Lipson v. The Queen
The case coming before the Court involves a standard interest deductibility flip:
- The Lipsons entered into an agreement to purchase a home.
- Mrs. Lipson borrowed money from a bank and purchased shares of a family company from her husband.
- Mr. Lipson used the funds from the proceeds of the shares to buy the home.
- Mr. and Mrs. Lipson took out a second loan secured by a mortgage on the new home, and used the proceeds to repay the original loan.
Relying upon the income attribution rules in the Income Tax Act, it was planned that the net income from dividends on the shares or loss resulting from the payment of interest on the loan would be attributed back to Mr. Lipson. Mr. Lipson claimed as a deduction the interest expense net of the dividends on the shares. His position was that the interest deduction was justified on the basis that interest on borrowed money used to repay a loan made for an eligible purpose can be deducted. The Minister denied the interest deduction and the taxpayer appealed to the courts.
The Courts’ Decisions
The Tax Court of Canada considered the matter with reference to the GAAR (the General Anti-Avoidance Rule), an overarching rule in the Income Tax Act that can attack a legitimate tax plan for being a "misuse or abuse" of the rules. Because the taxpayer in Lipson admitted the transactions were avoidance transactions within the meaning of subsection 245(3) of the Income Tax Act, the sole issue was whether the transactions constituted an abuse or misuse under section 245 of the Act.
Justice Bowman determined that the overall purpose of the taxpayer’s transactions was to “to make interest on money used to buy a personal residence deductible.” Justice Bowman held that since none of the relevant provisions relied on by the taxpayer contemplated such a purpose, the transactions were an abuse and misuse of the Act. Justice Bowman concluded:
The Supreme Court has given us some fairly clear guidelines on how to apply section 245 and it has also put some stringent restrictions on its application. However, if section 245 is to serve any purpose it must be applied to the very sort of contrived transaction such as this one at which it is obviously aimed.
The word “however” signals that Justice Bowman was aware that his approach may have deviated from the “stringent restrictions on (the GAAR’s) application” set down by the Supreme Court.
The taxpayer appealed the decision to the Federal Court of Appeal arguing that by conducting the abuse and misuse analysis on the basis the borrowings were used to buy the home, rather than by reference to the transactions as they actually took place and the legal relationships which were created, Justice Bowman had improperly imported into the GAAR analysis the concepts of economic purpose and reality. The Court dismissed the taxpayer’s appeal, stating that Justice Bowman was entitled to give substantial weight to the series of transactions, and its purpose, and could see no basis for interfering with the Tax Court decision.
What does it all mean?
The Court in Singleton determined that absent a sham or specific provision in the Income Tax Act to the contrary, the economic realities of a transaction cannot be used to recharacterize a taxpayer’s bona fide legal relationships. But the Singleton decision was pre-GAAR and the Lipson decision has demonstrated two things with respect to the application of the GAAR to interest deductions: firstly, the GAAR can be applied to disallow the deduction of interest and, secondly, the Courts are inclined to give substantial weight to the overall purpose of a series of transactions in determining whether the deduction of interest in a particular case is abusive.
So does this mean the substance or “economic reality” of interest deductibility transactions will override bona fide legal relationships? Tax practitioners are looking to the Supreme Court to provide clarity in this area. When the appeal is heard this April, it is hoped that the Court will clarify whether the GAAR can apply solely on the basis that a series of transactions was carried out with the overall purpose of obtaining an interest deduction (or a larger interest deduction), or whether there needs to be further avoidance aspects, such as the use of the attribution rules, for example, that make the transactions more offensive. If it is the former, the decision could see tax practitioners rethinking long-standing interest deductibility arrangements. In any event, anyone involved in or contemplating an interest deductibility arrangement should be seeking tax advice from a licensed practitioner.
So, will the Supreme Court let us be Happy? We’ll find out soon enough.
Nicole Ewing is an associate with BrazeauSeller.LLP. Nicole's practice focuses mainly on tax and estate planning.
About the Author: BrazeauSeller. LLP is an Ottawa business law firm that provides expert legal counsel, innovative solutions and responsive service to its clients. As the exclusive Ottawa member of Meritas Law Firms Worldwide, BrazeauSeller is able to provide its clients with access to trusted, dependable legal representation anywhere in the world, that their business takes them.
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