How Exposed Is The Smith Manoeuvre To The Lipson Case

Numerous readers have contacted me regarding the current Lipson case and it's potential affect on the Smith Manoeuvre. When it comes to legal matters, I usually contact a lawyer for more information. It just so happens that the blogger behind Thicken My Wallet is a former lawyer and is more than willing to help. Below are his thoughts on the Lipson case. A warning though, the article is a bit long but an essential read for those considering the SM.

MDJ has asked me to guest-post on the legal risks of the Smith Maneuver (the "SM") as it related to the Lipson Case which is now being heard by the Supreme Court of Canada. The Lipson case has thrown considerable confusion into the ability of the SM to with-stand audit scrutiny.

I have summarized the Lipson case thus far and provided some comments and observations. If you are looking for particular legal advice on this case then I will be up-front and say no one, including me, can provide advice on this matter given the Supreme Court of Canada has yet to render a decision on the appeal.

Having said that, I wanted to take this opportunity to try to cut through the noise of the Lipson case and take a look at the SM more contextually (wish me luck).

For definitional purposes, I use the term "SM" to describe any type of transaction whereby the interest on mortgage payments on a principal residence are claimed as deductions (there are various variations of the SM and not just one involving converting an existing mortgage to a HELOC to purchase securities or investment real estate).

The Facts

The Lipon's engaged in a series of transactions as follows:

Earl and Jordanna Lipson bought a home in Forest Hill in Toronto;
Ms. Lipson obtained a $562,500 loan NOT to buy the house but for Ms. Lipson to buy shares in Mr. Lipsons private held corporation;
Mr. Lipson then used the $562,500 of funds invested by Ms. Lipson to purchase the home;
A mortgage for $562,500 is obtained which is then used to repay Ms. Lipson's $562,500 loan referenced in step #2.

In and of itself, since step #2 involved "....borrowed money used for the purpose of earning income from a business or property...", the interest payable is fully tax deductible.

Step #4, in isolation, involved interest paid on refinancing which, under section 20(3) of the Income Tax Act (Canada), allowed the interest from this loan to also be fully tax deductible.

Why the Interest Deduction was Denied

The deductibility of the interest payments was denied by CRA under what I like to call CRA's kitchen sink defense (when all else fails, throw the kitchen sink at it): the general anti-avoidance rules (GAAR) of the Income Tax Act which allows CRA to deny a deduction if there is "misuse or abuse" of the tax rules.

The Courts agreed that GAAR could be invoked to deny what was otherwise a series of tax planning steps which fell well within the rules of deductibility but, as a whole, the transaction was a misuse or abuse of the rules.

Of significance, Justice Bowman, the trail judge, placed great weight on the fact the overall purpose of the series of transaction was "to make interest on money used to buy a personal residence deductible" which, under our tax laws, cannot be deductible but for some type of supportable tax transaction(s) (it is the exact opposite in the U.S. where interest is deductible).

Observations on the Court Decisions

There are several observations which can be made out of the decisions thus far.

The Lipson case, thus far, does NOT over-turn the Singleton case and the deductibility of interest from borrowed money used for earning income through business/investments etc. The case instead addresses how far is too far for this type of transaction. They are two fundamentally different issues- the concept of the SM has not been over-turned. The question is how far can someone take it (which is the essence of any case involving GAAR)?
The Lipson conceded at trial that there was a tax benefit and, more importantly, the transaction was an "avoidance transaction" under the tax rules. It is a really poor analogy but, in plain English, it was tantamount to admitting guilt in a criminal trial but arguing the cops investigated you unconstitutionally so you should get off. Reading between the lines, and this is my opinion alone, the Lipson's lawyers made the calculation that the Courts would be loathe to hand CRA carte blanche over when they could invoke GAAR and assumed the Courts would rein in the power of the state. I suspect this calculation was influenced in part by several losses CRA suffered over GAAR and SM before this trial. Critics of the decision have indicated that Justice Bowman went against recent case law on the matter which sided with tax-payers. The question becomes will the Supreme Court of Canada agree with Justice Bowman and rule that people have taken a good thing too far?
The Lipson's, in the eyes of the Court, were aggressive in their tax planning. There was not an attempt to structure their transaction as estate planning or commercial tax structure (examples Justice Bowman gave where the deductibility of interest would have been generally supportable in his eyes). There has been some criticism in some legal circles that Justice Bowman's decision was merely a "smell test" and did not contain sufficient legal direction (which may explain why the Supreme Court of Canada is hearing the appeal). This is now in the hands of the Supreme Court of Canada to decide.

Supreme Court of Canada ("SCC") Appeal

The SCC has granted leave to hear the Lipson's appeal with the hearing scheduled for April 23, 2008 (which likely means a decision sometime in the late summer/early fall of 2008 based on the Court's work rate).

This appeal is purely on an appeal based on errors of the law. The summary of issues can be found here.

Again, please note that the issue is whether the transaction constitutes an "abuse" of SM and not a challenge to SM itself. I am not going to remotely guess what the Court will decide other than to reiterate that the SCC will be not be asked to overturn SM (although judicial discretion does allow the SCC to address this issue).

A Few Final Thoughts

The Singleton case (which was the seminal decisions upholding the deductibility of interest in a SM type of structure) has analogous fact scenario but GAAR was never raised as a defense. It merely looked at whether the series of transactions were within the tax rules.
Whenever a particular tax structure goes mainstream, and is no longer the sole domain of the rich, CRA attempts to shut down the structure all together. A recent example of this is their high profile crack-down on tax shelters and Minister of Finance musing about scrutinizing Canadians with off-shore bank accounts. This may be the latest example of this pattern. SM, in essence, got too popular for its own good and, regardless of the decision, CRA may begin to scrutinize all SM's with a greater frequency since the SCC will most likely give some clarity on when and where the CRA may challenge the SM using GAAR and, donuts to dollars, CRA will use this to their advantage (after all, the economy is slowing down and CRA will need to find sources of tax revenue elsewhere).
Thus, for those wondering whether they should attempt a SM, here is your worse case scenario: CRA is given sufficient guidance by the SCC to deny variations of the SM under GAAR. Thus, the question becomes, if interest deductibility is denied, is the profit on business income greater than the cost (i.e. interest payments) of obtaining borrowed money? If profits are being created now purely because interest can be deducted under a SM (i.e. your profit is purely tax-driven and not due to any particular investing acumen), one's exposure is higher than if profits are made regardless of deductibility since if the SM does not survive audit scrutiny, one may be in a negative cash flow position.

I apologize for the long post (it's the lawyer in me) but the essential question you should ask yourself with your professional team (and, please, a SM is not a DIY exercise) is:

Do I have the investing skill to make more money on my investments than the interest I have to pay on a HELOC even if the interest is not tax deductible?

If the answer is yes, then the decision is really yours to make as to whether you have the risk tolerance to undertake quite a complicated structure. If the answer is no, and the profits are made purely for tax write-offs, please consult with your professionals for sober second (and third) opinions. Any type of business/investment which relies upon tax deductions alone to turn a profit should be avoided since the certainty of those deductions cannot be guaranteed.

Is it just HELOC or bust?

I would like to mention, as a side-note, that leveraging the equity in one home is not the only option to obtain borrowed money where interest is deductible. A secured line of credit can be obtained if one has sufficient assets (I know my bank will grant me a secured LOC greater than $50,000). Since most people's biggest asset is their principal residence, the principal residence is, indirectly, being used as collateral for that loan. In essence, it is no different than what some day-traders did earlier this decade- put up a personal guarantee in order to access funds to trade on the market.

Since the security on a secured LOC is being registered in the personal property registry, and not as a mortgage against title, it removes some of the audit scrutiny issues raised in the Lipson case since the interest on mortgage payments is not being deducted but the interest on the LOC is. This type of financing does not give to you the quantum of funds a HELOC does but removes the fundamental objection of CRA in the Lipson case. Yes, you cannot claim interest deductions on your mortgage but will you sleep better at night trading off the loss of deductions with a smaller chance of audit scrutiny?

The reason why it is not pushed much is because mortgage brokers do not make money off of it so there is no industry gain to pushing this. However, this type of structure does not fundamentally change the issue of whether on has sufficient risk tolerance and investment acumen to undertake any leveraging to invest. Again, please seek professional advise about this type of structure.

For those who are on the fence about SM, I have posted on taking a more contextual approach to this issue before.

Think carefully about a SM. Removing even the uncertainty of the Lipson case, it is a complicated structure to arrange and please do seek qualified professional advice on this matter.

This post is for informational purposes only and should not constitute advice of any kind whatsoever. Please consult your lawyer and accountant if you wish to seek advice on this or any tax-related matters.

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