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The Smith Manoeuvre and the Singleton Shuffle bite the Dust.

I hate to feel smug, but what they hell, every once in a while it is ok. Especially after all the crap unloaded on me over my article in REM and then Bob Arron picking up the article in the star and then the ensuing attack on him and I. You would think we had insulted the Holy Grail.

I am proud to say that I think we successfully prevented all our clients from getting involved with this. I was so loud and determined to make sure everyone knew to say away from this tax scheme.

So last week the long awaited judgment came down from the Supreme Court. The final word is in.

The Lipson versus Canada was the final word case and the game of over. You can not convert your home mortgate to a tax deductible mortgage. Check out my previous blog article on the Smith Manoeuvre, what I wrote is now the guiding light on the matter.

The majority decision was written by two criminal lawyers, a family lawyer and a labour lawyer, and the only Justices who actually know something about tax were in the minority.

While there are complaints that the ruling in the Lipson case did not clear up the matter as to how to know when GAAR applies and when it does not. I think the matter is pretty clear.

GAAR itself is pretty clear to me…. the simple solution is if your primary purpose is to reduce tax… it is wrong… if saving taxes is secondary, and you have the documentation to prove it… then there is nothing to worry about you can deduct the interest for investment loans. So long as the masters of muddy water try to invent phony schemes and paper for untrue diversionary reasons, then they will continue to get caught in grapples of GAAR.

That is not to disagree that the tax system is inept, unfair or unethical and that CRA previous publications on the matter were ambiguous. The end result is now that now thousands of Canadians to be hit with serious penalties and interest. CRA has known this stuff for years but do nothing because it is a good investment for them to let citizens blunder.

For every single person who played this game, they can expect to get audited. The CRA computers can easly identify every homeowner who has unreasonable interest deductions.

I sure won’t complain because my company is here to help victims who got trapped in the sexy nature of converting their taxable mortgages to tax deductible interest deductions. They now become prime prospects for a WNBC rescue mission.

We have our defence strategies worked out to mitigate damages. I will write on this later. CRA will claim gross negligence and will likely go for 100% penalties plus interest.

Following is further information on this topic. Also check out my previous blog article.

So I am going off to have a nice glass of wine. I think I will have a bottle of Chateau Gloat 2009,

Best Regards

Dan

Lipson v Canada(F.C.)(32041)(March 16, 2007)
“The taxpayer E and his wife entered into an agreement of purchase and sale for a family residence. The wife borrowed $562,500 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 $562,500. 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, J, conducted similar transactions. The Minister of National Revenue 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 ss. 20(1)(c), 20(3), 73(1) and 74.1 of the Income Tax Act and the taxpayers’ appeals were dismissed. The Federal Court of Appeal upheld that decision”.

Canada Court Strikes Mortgage-Interest Deduction Plan (Update1)
By Joe Schneider
Jan. 8 (Bloomberg) — Canada’s high court struck down a method some wealthy families use to gain tax deductibility for mortgage interest, ruling that a husband’s application of his wife’s deduction to his own income is abusive and illegal.
The Supreme Court of Canada, in a 4-3 decision today, upheld a federal ruling that dismissed a tax plan devised by Toronto residents Earl and Jordanna Lipson. Mortgage interest in Canada isn’t tax-deductible, though interest paid on investment loans generally is.
The Lipsons agreed to buy a house in Toronto in 1994 for C$750,000 ($633,000). Jordanna Lipson borrowed C$562,000 from the Bank of Montreal to buy shares in the family company, Lipson Family Investments Ltd., from her husband. The Lipsons then obtained a C$562,000 mortgage from the Bank of Montreal and used it to pay off the share loan. Earl Lipson deducted the interest on the mortgage loan on his 1994, 1995 and 1996 tax returns.
“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,” Justice Louis LeBel wrote on behalf of the majority. “The ensuing tax benefit of the attribution of Mrs. Lipson’s interest deduction to Mr. Lipson is.”
The ruling won’t affect Canadians who borrow against the value of their home to buy investments, making their mortgage interest in effect tax-deductible, Jamie Golombek, managing director of tax and estate planning at CIBC Private Wealth Management, said in a telephone interview.
‘Plain Vanilla’
“That strategy, based on this ruling, is still alive and well,” Golombek said. “The plain vanilla debt-swap strategy should be fine.”
Golombek, who moved to CIBC last year after 12 years as vice president of taxation and estate planning at AIM Trimark Investments, said the case has been closely followed by Canadian tax planners. People lined up outside the Supreme Court in April, when arguments were heard, to gain a seat inside the courtroom, Golombek wrote on his blog at the time.
LeBel said the federal tax department properly relied on a law prohibiting abusive tax avoidance — the general anti- avoidance rule, or GAAR — to deny Lipson’s deduction. Justice William Ian Binnie, in dissenting, said the anti-avoidance rule will make it difficult for people to plan their taxes properly.
“The GAAR is a weapon that, unless contained by jurisprudence, could have a widespread, serious and unpredictable effect on legitimate tax planning,” Binnie wrote.
The case is Between Earl Lipson and Her Majesty The Queen, No. 32041, Supreme Court of Canada (Ottawa).
To contact the reporters on this story: Joe Schneider in Toronto at jschneider5@bloomberg.net.
Last Updated: January 8, 2009 14:55 EST

TAX: GAAR (General anti-avoidance rule)
Lipson v Canada(F.C.)(32041)(March 16, 2007)
“The taxpayer E and his wife entered into an agreement of purchase and sale for a family residence. The wife borrowed $562,500 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 $562,500. 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, J, conducted similar transactions. The Minister of National Revenue 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 ss. 20(1)(c), 20(3), 73(1) and 74.1 of the Income Tax Act and the taxpayers’ appeals were dismissed. The Federal Court of Appeal upheld that decision”.
S.C.C. held (4:3 - with 2 separate sets of dissenting reasons) the appeal is dismissed.
Justice LeBel (in majority) wrote as follows (pp. 9-10, 12-13, 21-22):
“It has long been a principle of tax law that taxpayers may order their affairs so as to minimize the amount of tax payable (Commissioners of Inland Revenue v. Duke of Westminster, [1936] A.C. 1 (H.L.)). This remains the case. However, the Duke of Westminster principle has never been absolute, and Parliament enacted s. 245 of the ITA, known as the GAAR, to limit the scope of allowable avoidance transactions while maintaining certainty for taxpayers (Canada Trustco , at para. 15). In brief, the GAAR denies a tax benefit where three criteria are met: the benefit arises from a transaction (ss. 245(1) and 245(2)); the transaction is an avoidance transaction as defined in s. 245(3); and the transaction results in an abuse and misuse within the meaning of s. 245(4). The taxpayer bears the burden of proving that the first two of these criteria are not met, while the burden is on the Minister to prove, on the balance of probabilities, that the avoidance transaction results in abuse and misuse within the meaning of s. 245(4).
…In determining the purpose of the relevant provision(s) of the Act, a court must take a unified textual, contextual and purposive approach to statutory interpretation (Canada Trustco, at para. 47). This approach is, of course, not unique to the GAAR. As this Court confirmed in Kaulius, the approach to statutory interpretation is the same for provisions of the ITA as for those of any other statute: it is necessary “to determine the intention of the legislator by considering the text, context and purpose of the provisions at issue” (Kaulius, at para. 42; see also Placer Dome Canada Ltd. v. Ontario (Minister of Finance), 2006 SCC 20, [2006] 1 S.C.R. 715, at paras. 21-23).
…At this step, it is important to identify which provisions are associated with each tax benefit. Here, it is clear that the tax benefit of deductibility of interest relates to ss. 20(1)(c) and 20(3). On the other hand, the tax benefit arising out of Mr. Lipson’s use of the attribution rules, namely the possibility of deducting the interest to reduce his income, is linked with ss. 73(1) and 74.1(1). By virtue of these provisions, Mr. Lipson retains, for tax purposes, the stream of income from the shares sold to his wife but is able to deduct the interest payments on the mortgage from his income.
…In summary, 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, but the ensuing tax benefit of the attribution of Mrs. Lipson’s interest deduction to Mr. Lipson is. It follows that this latter tax benefit can be denied under s. 245(2), which is triggered because the transactions in the series include the attribution of the interest deduction under s. 74.1(1) and this attribution frustrates the object, spirit and purpose of that provision. I must now briefly consider the tax consequences of the denial of the tax benefit and the application of the GAAR”.

This entry was posted on January 17, 2009 at 9:03 pm and is filed under Audits, Tax Topics, Tax Tips For Real Estate, The Law in Canada. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response or trackback from your own site.

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8 Responses to “The Smith Manoeuvre and the Singleton Shuffle bite the Dust.”

Tony Humble says:
January 24, 2009 at 5:37 pm
Hey Dan

I have written a couple of articles on the Smith Manoeuvre, one of which was in my guest column spot for the Financial Post. Your headline “the Smith Manoeuvre bites the dust” seems to be referencing the Lipson and Singleton cases in particular, which are transaction based, rather than the long term process that Smith’s book proposes. Wouldn’t the long term process support deductibility, as opposed to the “abusive” transactions that are represented by Lipson and Singleton. My article a few years ago held that SM helps people become investors while they still have a mortgage, and can benefit from the spread between deductible mortgage rates and deferred capital gains on investments. I still feel that is true, but your comments seem to cast all such “swaps” in the same light.

I am also aware of aggressive programs (presumably only used with high net worth clients) that use leverage and distributions from T-SWP accounts to accelerate the effect. Suitability would be the watchword here, of course, but as a process it would not seem to be abusive, as Lipson and Singleton clearly seem to be. What are your thoughts on this observation?

Thanks

Tony
Dan White says:
January 24, 2009 at 7:28 pm
Hi Tony,
Thanks for registering your reply to my blog.

I do a lot of tax work helping clients who are attacked by CRA and I do a lot of tax strategies. Therefore I am used to dealing with how CRA thinks about GAAR and other approaches they have to decrease tax deductions by citizens.

Basically I see this as fundamentally simple. 90% of an auditors time is in dealing with how expenses relate to business. Auditors and Appeals Officers have the right to assume facts in absence of statements of fact on business expenses. Investing is a business activity to earn interest.

Where the SM and the SS fall in with the Lipson case is that they all look at “conversion” as a predominant purpose of the procedure.

While as you state the SM takes the long term process, it still leaves a paper trail that leaves it smelling like an avoidance procedure. That certainly is how I see it. A key issue is always that if in your heart you know you are trying to beat the system by a coy procedure, you know you are really doing illegal tax avoidance. I see it a bit different than tax evasion.

The common thread in these strategies is to have mortgage interest become tax deductible by making them appear legitimate through various proceedures. No matter how you slice it, if you are playing that Game, GAAR will get you.

There is a ton of 680 News and other ads on “conversion of mortgage interest to tax deductible interest.” This is where things fall apart.

What the simple insight is…. just intend to borrow money to invest…and have the paper trail to prove it and you are fine. Just keep paying off your mortgage as a separate activity.

CRA loves these plans as they get triple the money when they collect.

I looked very closely at the SM because I really wanted to be sound. I love doing this stuff. But I was very sure that this would get caught in GAAR.

I hope this helps to see my perspective, if I can help further, please let me know.

Best Regards

Dan
Tony Humble says:
January 25, 2009 at 11:07 am
Dan

Thanks for your in-depth response. I see your point. It’s fine - important in fact - to pay off your mortgage, and it’s fine to use a line of credit secured by your home to invest and generate investment income (you said interest, but I think you meant income?), but what’s not fine is to participate in or construct a program whose stated or obvious purpose is to avoid taxes, rather than to undertake either of the above. Would that be a fair assessment of your point of view as regards GAAR?

One observation I’d like to make is that the “genius” of the Smith Manoeuvre, as I see it, was the invention of the re-advanceable line of credit that increases as the amortizing mortgage decreases. Anything one does to reduce the principle, which happens to generate non-deductible interest, would appear to be a good thing; and depending upon your point of view on leverage, anything one does to invest for the future on a regular, averaging basis would also appear to be a good thing, especially if the interest you’re charged on it is deductible.

My final question to you then is “if the promoter were not to advertize tax savings as main purpose of a program, or construct a program that is clearly set up for the purpose of converting a mortgage to tax deductibility, but to indicate that the paydown of a mortgage and the accumulation of an investment are the main reasons for the program, the tax savings being incidental, would that fact help the consumer when CRA comes calling, as long as the mortgagor keeps clear records of his investments, as you indicate in your response?”

Interesting debate!

Cheers

Tony
Dan White says:
January 25, 2009 at 12:12 pm
Hi Tony,

I think you have it pretty clear now.

If I were going to do this program which has some smarts built in, (I don’t agree that it is genius in anything but marketing.) I would simply freeze/identify my existing mortgage amount, and then I could taking my allowable 10% annual mortgage prepayment allowed by law. The financial penalty for exercising the legal right to prepay is pretty small.

I would make my mortgage payments regularly as usual… Showing I am not playing games with my non tax deductable mortgage payments. At the end of each year, I would make my 10% prepayment. Simple, clear and legal. No games at this juncture.

I would arrange a HELOC, and invest my money in my chosen area. I would claim the income from the program/business and would take that money to make annual payments on my first mortgage. I would claim the HELOC interest as tax deductable.

I would consider not using the income from my investments to pay down my HELOC. Rather I would put the returns back into my HELOC funded business, continue writing off the interest, and use the income to generate more returns on my income.

I see debt as both good and bad depending on the type of debt.

It is bad if you are paying for something decreasing in value.

I see debt is good if it is being used to accumulate wealth. That is why I would not pay down the HELOC… It is a good debt with tax deductible interest.

I would do my investment as an active business and not a passive investment activity. (I did mean income in my previous response.)

My right to pay off my mortgage with after tax dollars is undisputable. However a mortgage is a good debt and can only be paid with after tax income. To try otherwise will trap the person in GAAR.

So long as I am not doing the conversion process, I am fine.

I would be happy to defend any client who was doing it my way, in court as I know I would win.

In response to your last question the answer is “yes.”

How I would word it would be along the lines of…..

Convert your home equity to a money making machine. We can show you exactly how to do this and how you can grow your wealth. If you do this right, the side benefit to earning greater wealth is savings on income taxes. Interest paid on genuine business activities and specified investments is tax deductable. As a matter of fact, if you do this right, none of your income from this process will be taxable and you could earn enough income to more than pay off your home debt, should you decide that is what you want to do.

Best Regards

Dan
Tony Humble says:
January 25, 2009 at 12:59 pm
Thanks again Dan

Well, taxes are your game, and your expert insights are appreciated, but mortgages have been my game for quite a while, and you apparently haven’t had one for a number of years! I say that kindly, and in jest, because total annual prepayment privileges with the vast majority of lenders are now either 15% or 20% (20 especially, but not exclusively in variable rate mortgages which except for when 5 year mortgages were 4.25% I have consistently advocated). Also, most lenders now have sophisticated mortgage systems, and to compete with mortgage brokers even banks have had to set up prepayments to be made on any payment date, as long as they are $100 or more. If you have a weekly payment mortgage you can make 52 extra payments if you want!

This factor is what has led to the programs that incorporate extra payments monthly, typically but not always from T-SWP distributions. It also facilitates more rapid amortization for the frugal who somehow manage to find extra money to pay the mortgage down quite frequently, but not necessarily on the anniversary date.

Anyway, your tax/CRA insights are very helpful, and especially encouraging for me, as I am advising a company on structuring a rapid mortgage paydown program that is also a business, and that has incidental tax benefits that are by no means the main purpose. I will certainly heed your pragmatic suggestions in this regard.

Thanks again!

Cheers

Tony
Dan White says:
January 25, 2009 at 5:20 pm
Hi Tony,

I like your response.
It is good that you are the mortgage guy and set me straight. Thanks for that.
I was operation on the belief of the 10% mandatory privilege of paying off a mortgage, even without that written in the contract. This was based on a company I am aware of promoting this in the market. Normally I tend to check my facts. This time I did not because one would assume that the company would have to be pretty sure of themselves to promote it as part of their business. I did some searches now … And I don’t see anything to that effect. Interesting.

I find it interesting that you are really into mortgage strategies… Can you tell me more about why people deal with you… What sets you apart from other brokers… I am always looking for people who know their stuff and go the extra mile.

Feel free to bounce ideas off me on tax or tax reduction strategies.

Also if you are interested… I have a joint venture going where we are going on line with a bookkeeping system that I developed. It is the only audit ready accounting software that I know of… It teaches the user about finance… Let me know if you are interested as it could be very useful for you in working with your clients.

Best Regards

Dan
Tony Humble says:
January 25, 2009 at 6:46 pm
Hi Dan

Well we can’t all be masters of all trades, to paraphrase the old saw. I have also been corresponding with Fraser Smith, who is a planner, not a mortgage broker, so I think between the three of us we have it covered (if we can agree!). I first met Fraser just before I wrote my article three years ago, and he was very pleased with my good friend Jon Chevreau’s FP article last Saturday sub-titled “Smith Manoeuvre holds up in CRA Challenge”. I hadn’t seen that piece until Fraser pointed it out out me earlier today, and it does indeed seem to contradict your GAAR opinion. Going back to your original response, it seems that as you point out it is all in the promotion and intent.

I have been a student of mortgages for 2 decades, and I am all over any system that helps people get out from under the burden of any loan that is serviced with after tax income. Fraser calls that “bad debt” and that’s the way I think of it too. You call it good debt, but I assume you mean in comparison to consumer debt. I think of them as the same, again because you have to pay tax before you make the payments. My strategies are ALWAYS to get rid of both!

There is a very interesting system out of the US called “Money Merge” that is excellent for the US market, and works well there, but doesn’t carry the same impact in Canada, to my mind. It coaches people who have some discretionary income to maximize their prepayments. It is also US$3,500, unfortunately. My (Canadian) approach is to help people achieve the same end by creatively using the very same readvanceable type of mortgage that Fraser had such a major hand in creating.

Finally I would indeed like to talk to you about your accounting system. It sounds as though it could work very well with what we are planning to do. Let’s grab a coffee and talk about it. Drop me a line and let’s do it in the next few weeks.

Cheers

Tony
James says:
November 11, 2010 at 11:16 pm
Dan, say you have this situation:

-Person buys a bachelor (Property A) and lives in for a few years being financed on a HELOC.
-Person decides to buy a new 1+ den (Property B), but uses the freed up room on the HELOC as down payment.
-Would all of the interest be deductible? If not, how would it be possible to make it so?

The down payment interest is tax deductible. My warning…. tax problems re created by people not understanding how to set things up to avoid tax problems later. CRA is very good at disallowing expenses for reasons that taxpayers don’t understand. So if you are going to do planning on growing your wealth, understand that CRA sees your profits as their money.

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The Smith Manoeuvre and the Singleton Shuffle bite the Dust.

8 Responses to “The Smith Manoeuvre and the Singleton Shuffle bite the Dust.”

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