Interest deductibility: Uncertain in light of Lipson?

The Income Tax Act (Canada) distinguishes between interest paid or payable by taxpayers on account of a business venture and a personal venture. Essentially, interest expense incurred on a business loan will generally be deductible to the taxpayer or, in some cases, may be capitalized. Contrast this treatment to personal loans, where interest on such loans is not deductible. As such, it is not hard to imagine the incentive to develop tax plans and to organize one's affairs in a manner which qualifies as much interest expense as possible as tax deductible.

Singleton¹, prior to Lipson², was the seminal case for this type of tax planning. In the Singleton case, the taxpayer was a partner of a law firm in Vancouver, B.C. The taxpayer had a significant amount of equity built up in his partnership account. In order to purchase a house, the taxpayer accessed his partnership equity. The taxpayer then borrowed money to replace his depleted partnership equity. The Canada Revenue Agency challenged the deductibility of the interest expense claimed, on the principle that the borrowed money was effectively used to finance the purchase of a house to be used personally. In rejecting the taxpayer's appeal, Bowman C.J. applied a "true economic purpose" test. Based on this test, the court noted "the true economic purpose for which the borrowed money was used was the purchase of a house, not the enhancement of the firm's income earning potential by a contribution of capital."³ Fortunately for the taxpayer, the Federal Court of Appeal overturned the Tax Court decision on the principle that Bowman C.J. had applied the wrong test. The majority for the Federal Court of Appeal stated:

The Minister has presented no logical reason why, if a partner invests his own funds in his firm, he cannot withdraw those funds for personal use and refinance the investment in the firm with borrowed money in respect of which interest is deductible.⁴

Furthermore, the majority for the Federal Court of Appeal felt they were bound by the decision of the Supreme Court of Canada in Bronfman Trust⁵, which stated that the courts cannot ignore the direct use to which a taxpayer puts borrowed money. The majority concluded that so long as the direct use of the borrowed funds satisfied the requirements of the Act, the interest would be deductible.

In rejecting the Minister's subsequent appeal, the Supreme Court also rejected Bowman C.J.'s true economic purpose test. The court held:

22 [. . .] the Tax Court Judge, in searching for the "true economic purpose", applied the wrong legal test.

43 [. . .] it is irrelevant that by his own admission the respondent structured the transaction for tax purposes. Courts cannot search for the "economic reality" or the "bona fide" purpose of the transaction in this case. In giving effect to the legal relationships underlying the transactions here, it is obvious that the borrowed money was used directly to refinance the respondent's capital account. This is a direct, eligible use within the meaning of s. 20(1)(c)(i) of the Act. The respondent was entitled to deduct the interest expenses.

Based on Singleton, tax professionals and their clients had some measure of comfort in deducting interest expense so long as the direct use test had been met in terms of the particular loan. This certainty, consistency and predictability has been put into serious doubt as a result of Lipson. In Lipson, the taxpayer attempted to conform to the parameters set out in Singleton. In this case, the taxpayer sold his shares in an investment company to his spouse. The taxpayer's spouse borrowed money to pay for the shares. The taxpayer then used the proceeds of disposition received on the shares to acquire a house. While recognizing that the impugned transaction technically complied with the interest deductibility provisions of the Act, the court upheld CRA's reassessment based on the General Anti-Avoidance Rule ("GAAR"). The reasoning of Bowman C.J., channelling his reasoning in Singleton, was as follows:

9 [. . .] [t]he purpose of the scheme was to create the impression that money was borrowed to repay money used to buy shares when in reality it was borrowed to buy a house and to allow Earl to deduct the interest on borrowed money used to buy the house.

32 In this case I am not looking to any "overarching policy" that supersedes the specific provisions of the ITA. I am simply looking at the obvious purpose of the various provisions that are relied on and have concluded that those purposes have been subverted and those sections turned on their heads. I mentioned above that section 245 [the GAAR] must itself be subjected to a textual, contextual and purposive analysis. If there ever was a case at which section 245 was aimed, it is this one.

The Federal Court of Appeal upheld the lower court decision and stated:

53 Although no single element is determinative of whether there has been abusive tax avoidance, Bowman C.J. gave substantial weight to the series of transactions, and its purpose, something which he was entitled to do.⁶

In April 2008, the Supreme Court heard the taxpayer's appeal but has yet to issue their judgment. It is hoped that the Supreme Court will take this opportunity to provide some certainty, consistency and predictability on this type of direct use interest deductibility tax planning. Once the Supreme Court has ruled in this case, we will provide a summary of this decision and discuss any implications it may have on Singleton-type interest deductibility tax planning in the future.

1. Singleton v. R., [2001] 2 S.C.R. 1046, 2001 SCC 61 (S.C.C.) ("Singleton").
2. Lipson v. R., [2006] 3 C.T.C. 2494, 2006 TCC 148 (T.C.C.) ("Lipson").
3. Singleton v. R., [1996] 3 C.T.C. 2873, 96 D.T.C. 1850 (T.C.C.) at para 17.
4. Singleton v. R., [1999] 3 C.T.C. 446, 99 D.T.C. 5362 (F.C.A.) at para 14.
5. (1987), 87 D.T.C. 5059 (S.C.C.).
6. Lipson v. R., [2007] 3 C.T.C. 110, 2007 FCA 113 (F.C.A.) at para 53.