Supreme Court Says Lipson Strategy Runs Afoul of GAAR

In a split decision, on January 8, the Supreme Court upheld the Tax Court of Canada's decision that Earl and Jordan's Lipson strategy to deduct their mortgage interest had breached the general anti-avoidance rules (GAAR).

The Lipson's strategy was an extension of the strategy commonly known as the "Singleton Shuffle", named after Vancouver lawyer John Singleton whose strategy was upheld in a 2001 Supreme Court decision.  His strategy is now commonly used by investors to convert non-deductible personal debt into deductible debt.  The strategy involves selling existing investments, using the proceeds to pay off or pay down a mortgage on the personal residence and then taking out a mortgage to repurchase the investments.  The Supreme Court confirmed that this strategy is a valid way for the taxpayer to arrange his affairs to minimize his income tax liability.

The Lipson's took the strategy one step too far and, in doing so, ran afoul of GAAR.  Here was their strategy:

1. Mrs Lipson borrowed money to purchase shares in their family investment corporation from her husband at fair market value.  (She would normally not qualify for the loan but promised to repay it the following day and replace it with a mortage on a home show would then own.)
2. Mr. Lipson then used the proceeds to purchase a family home.
3. Mrs. Lipson then took out a mortgage on the home to repay the money borrowed to purchase the shares.

4. When filing his tax returns for 1994, 1995 and 1996, Mr. Lipson relied on the attribution rules to report the income on the shares in his income and deduct the interest expenses paid on the mortgage.

The net result of this strategy was that Mr. Lipson was reporting the same income on his return as he would have had he not sold the shares, and he was deducting the mortgage interest on a new home.  It was this last step - the use of the attribution rules to reduce his taxes that lead the Tax Court, and now the Supreme Court, that this transaction was an avoidance transaction (as defined in S. 245(4)).  As such, under 245(5) the deduction of the interest expense on the mortgage is disallowed.

Investors need not be concerned that the Lipson decision will have wider consequences - unless their strategies, too, rely on the attribution rules to transfer interest deductions on a intra-family transaction.  The "Singleton" strategy is still valid and allowable.

Had Mrs. Lipson had income of her own and reported the dividends on her return and claimed the interest deduction (as is allowed as the transfer was at fair market value), the strategy would not have been deemed an avoidance transaction and would therefore have been allowed.