Canadian Court Rules Against Mortgage Interest Deduction Scheme

by Mike Godfrey, for LawAndTax-News.com, Washington

12 January 2009

The Supreme Court of Canada has issued a key ruling in a keenly-watched case concerning the deductibility of interest against an individual's income and the ability of the Canadian Revenue Agency to wield the general anti-avoidance rule (GAAR) to strike down questionable tax arrangements.

The Supreme Court panel ruled last week in a split 4-3 decision that a taxpayer could not deduct interest payments on a residential mortgage because the arrangement was created with the sole purposes of avoiding tax. However, tax experts believe that the decision has effectively reinforced the right for taxpayers to deduct interest on loans used for investment, including mortgages on rental properties.

In the Lipson case, the taxpayer and his wife, Jordanna Lipson, entered into an agreement of purchase and sale for a family residence. The wife borrowed CAD562,500 from a bank to finance the purchase of shares in a family corporation. She paid the borrowed money directly to the taxpayer who transferred the shares to her. The taxpayer and his wife obtained a mortgage from a bank for CAD562,500. That same day, they used the mortgage loan funds to repay the share loan in its entirety.

On his 1994, 1995 and 1996 tax returns, the taxpayer deducted the interest on the mortgage loan and reported the taxable dividends on the shares as income when applicable. The brother of the taxpayer conducted similar transactions. The Revenue Agency disallowed the deductions for those taxation years and reassessed the taxpayers accordingly. The Tax Court of Canada dismissed the taxpayers’ appeals, holding that the series of transactions constituted a misuse of sections 20, 73 and 74 of the Income Tax Act. The Federal Court of Appeal upheld that decision.

Writing on behalf of the majority, Justice Louis LeBel noted that while the tax benefit of the interest deduction resulting from the refinancing of the shares of the family corporation by Mrs. Lipson is not abusive viewed in isolation "the ensuing tax benefit of the attribution of Mrs. Lipson’s interest deduction to Mr. Lipson is.”

In a statement regarding the ruling, the law firm McCarthy Tétrault, which represented the Lipsons, observed that the ruling "is an important precedent regarding the extent to which taxpayers are entitled to organize their affairs with certainty and predictability when incurring debt." The firm also stated that the ruling sets an important legal precedent on the interaction of the GAAR and the specific provisions of the Canadian tax legislation and could have implications beyond Canada's borders.

"The decision will have far-reaching ramifications for many commercial transactions that involve the deduction of interest. This case also has international implications because of the new rules denying the deduction of interest on certain foreign affiliate financings," the firm stated.

While the majority verdict argued that the Canadian government had legitimately used the GAAR to terminate the Lipsons' financial arrangement, Justice William Ian Binnie, one of the dissenting judges on the panel, warned that if not held in check by the courts, the GAAR could have "widespread, serious and unpredictable effect on legitimate tax planning."

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