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Earlier this month, the Supreme Court of Canada ("SCC") issued a decisive ruling that clarifies once and for all that the interest paid on a mortgage taken out to purchase a principal residence cannot be tax deductible under any circumstances (unless part of the house is used for business purposes.)
Background
The ruling in the case of Lipson v Canada, 2009 SCC 1 [Lipson], relates to a complicated series of transactions put into place by Earl and Jordanna Lipson back in 1994.
Initially, Jordanna borrowed $562,500 from the Bank of Montreal to buy shares in her husband's company at market value. She paid the proceeds of the share purchase loan directly to her husband. The next day, the couple bought a home for $750,000 and obtained a Bank of Montreal mortgage on it for another $562,500. Right after the house closing, the Lipsons used the proceeds of the mortgage to pay off the share purchase loan completely.
In 1994, 1995 and 1996, the husband deducted from his taxable income a total of more than $104,000 in interest expenses on the mortgage loan. The Minister of National Revenue disallowed the deductions and reassessed Lipson accordingly. The government's position was that the complicated series of transactions amounted to "abusive tax avoidance."
In this country, evading tax is illegal, but avoiding tax is – generally – acceptable, except when the avoidance is abusive. If the minister believes a tax avoidance scheme is an abuse and misuse of the Income Tax Act, the government can invoke the general anti-avoidance rule (GAAR) and deny the taxpayer's claimed deductions. That's what happened in Lipson.
When his deductions were disallowed under the GAAR rules, Earl Lipson took the minister to Tax Court, then the Federal Court of Appeal and ultimately, the Supreme Court of Canada. In a 36-page judgment with two separate dissents, the Supreme Court sided with the government and the two lower courts in a 4-3 ruling.
Commentary
Lipson may have serious ramifications for taxpayers who use schemes like the Smith Manoeuvre to attempt to convert the interest on their principal residence mortgage to a tax-deduction.
The seductive pitch for the Smith Manoeuvre on the promoter's website, www.smithman.net, reads, "Go ahead, make your mortgage tax deductible. Yes, it can be done. Yes, it's legal." The essence of the Smith Manoeuvre strategy is that each month the homeowner pays down a little bit of the principal owing on the home mortgage, and then borrows it back. The borrowed money is then invested and the carrying charges on that newly borrowed money only are tax-deductible.
But, according to Melanie and Robert McLister at canadianmortgagetrends.com, "it's not for everyone. There are both investment risks and serious tax risks. Your (investment) returns could be insufficient, CRA (Canada Revenue Agency) could invalidate your application of the strategy, or you could wind up in a negative amortization scenario if your house value falls." (A negative amortization occurs when the balance owing on the mortgage exceeds the value of the house.)
In my opinion, strategies like the Smith Manoeuvre are far too risky for the average homeowner. After the Lipson decision was released, tax specialist Dan White wrote me to say that taxpayers simply "cannot convert their mortgage to tax-deductible interest. The final verdict is in. ... The primary purpose of an activity dictates the final results in tax deductibility. They can borrow money against their house to invest and write off the interest ... so long as it is not just a manoeuvre."
Anyone tempted to participate in the Smith Manoeuvre or other strategies to try and make interest on a home mortgage tax-deductible should obtain tax advice from a qualified accountant or tax lawyer who is not selling anything except unbiased advice. Tax advisers who make a commission from selling participation in schemes like the Smith Manoeuvre may be in a conflict of interest and their advice may not be impartial.
Above all, taxpayers should not be misled by promises which appear to make all their home mortgage interest tax-deductible.
4 Comments
Just visiting for the first time and I must admit I do enjoy reading the summaries.
Out of curiosity, I saw the SCC docket published here, but what is missing is two cases that has been commented on elsewhere, at the Reconsideration stages.
The files are 32605 and 32746.
strange, this article says the opposite: http://www.mymortgageadvisor.ca/blog/?p=16
In the article she says "On January 8th, 2009, the Supreme Court of Canada gave its seal of approval to a commonly used manoeuvre that effectively makes mortgages tax-deductible, ruling that the technique is legal and “unimpeachable” under federal income tax laws."
and the error: "Where the Lipsons erred was in their shifting of income from Earl to Jordanna via a complex share transaction that allowed Earl to claim an interest expense which the Court said should have gone to Jordanna, thus violating the spirit of the Income Tax Act."
Bob is mixing up cases. The Libson case and a more standard case like the Singleton pass the test. Also, go to CRA's web site and type in IT533 go to section 31 (Interest Deductibility and Related Issues). See below....
Borrowing for investments including common shares
¶ 31. Where an investment (e.g., interest-bearing instrument or preferred shares) carries a stated interest or dividend rate, the purpose of earning income test will be met "absent a sham or window dressing or similar vitiating circumstances" (Ludco). Further, assuming all of the other requisite tests are met, interest will neither be denied in full nor restricted to the amount of income from the investment where the income does not exceed the interest expense, given the meaning of the term income as discussed in ¶ 10.
Where an investment does not carry a stated interest or dividend rate such as some common shares, the determination of the reasonable expectation of income at the time the investment is made is less clear. Normally, however, the CCRA considers interest costs in respect of funds borrowed to purchase common shares to be deductible on the basis that there is a reasonable expectation, at the time the shares are acquired, that the common shareholder will receive dividends. Nonetheless, each situation must be dealt with on the basis of the particular facts involved.
These comments are also generally applicable to investments in mutual fund trusts and mutual fund corporations.
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On September 28, 2001, the Supreme Court of Canada released its long-awaited decisions in Ludco (2001 SCC 62) and Singleton (2001 SCC 61). Both cases involved the question of whether interest payments were tax-deductible.
For interest to be an allowable expense, it must meet certain criteria. In general, the amount must be paid or payable pursuant to a legal obligation to pay interest on borrowed money that is used for the purpose of earning income from a business or property. Income from property does not include a capital gain earned from the sale of that property. Therefore, interest on borrowed money used to generate a capital gain will generally not be considered tax-deductible. Such a determination is always a question of fact.
In general, Bob by going to mortgage brokers for advise on TAX questions is like me, asking my brother-inlaw who fixes cars about what shares to buy. A better person (s) to talk to would be a chartered accountant at least!
I emailed Bob Aaron after his similar article in the Toronto Star that he check his sources before publishing an article. He quotes Dan White, who has no tax qualifications at all as far as I can find, and a mortgage broker - both on tax issues. Why would he not quote a tax professional?
I take exception to the quote: "After the Lipson decision was released, tax specialist Dan White wrote me to say that taxpayers simply “cannot convert their mortgage to tax-deductible interest." on 3 points:
1. The Lipson decision is unrelated to the Smith Manoeuvre.
2. Dan White has no tax qualifications.
3. "Converting mortgage to tax deductible interest" refers to the Smith Manoeuvre. I am an accountant with hundreds of clients that have done this by borrowing to invest with no issues from CRA.
The Lipson case and Smith Manoeuvre are unrelated. The Smith Manoeuvre is just borrowing to invest. There is no question it passes the tax rules and IT-533. It is clearer if you ignore the mortgage. The tax issues are simple borrowing to invest.
The Lipson case involved a series of transactions that would each be fine, but taken collectively was determined to be abusive under GAAR. The abusive part was using the attribution rules against their purpose.
Bob Aaron loses credibility when he quotes Dan White. Dan White is 100% wrong. As far as I can tell, he has no tax qualifications at all. He is not an accountant. He is flogging a ridiculous tax scheme involving creating a series of sham businesses and claiming losses on each. For a laugh, read Jamie Golombek's article called "Dumb Write-offs":
http://www.jamiegolombek.com/article...article_id=916
I think it reflects poorly on the legal profession when a lawyer publishes articles quoting people without qualifications that are wrong on the issue.
Ed
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Ed Rempel, CMA, CFP
Certified Financial Planner
Ed Rempel & Associates
Armstrong & Quaile Associates
Web site: http://www.edrempel.com
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