Form Over Substance 

FROM: JUL-AUG 2008 ISSUE | BY VERN KRISHNA

Harking back to the days leading up to another Conservative government in Ottawa, Joe Clark won the 1979 federal election by promising that he would allow Canadians to deduct home mortgage interest for tax purposes. Unfortunately for homeowners, the Clark government fell in nine months before passage of the bill enacting the legislation. Since then, taxpayers have resorted – with varying degrees of success – to arbitrage to make their personal mortgage interest tax deductible.

Interest arbitrage occurs where a taxpayer exchanges non-deductible interest for deductible interest through a series of transactions that allow form to prevail over substance. In the simplest example, an individual sells stock worth $500,000 to buy a house and then borrows $500,000 to repurchase identical stock. The interest on the borrowed money should be deductible because the taxpayer uses the funds directly to purchase investments.

The Westminster principle (named after the 1935 decision of the House of Lords in the Duke of Westminster case) is that a taxpayer can legally arrange his affairs to minimize the tax payable regardless of motive. However, Parliament enacted the general anti-avoidance rule (GAAR) in 1988 to curb so-called “abusive” tax avoidance. GAAR defines an “avoidance transaction” as one that a taxpayer undertakes for tax benefits and that does not have a primary bona fide non-tax purpose. However, GAAR does not apply to tax motivated transactions if the transactions do not misuse or abuse the Income Tax Act.

In the Lipson case, a married couple engaged in a series of transactions intended to arbitrage non-deductible interest on their mortgage into deductible interest for tax purposes. The transactions – which purported to finance the purchase of investment property – were legal under specific provisions of the Act. However, GAAR looks at the cumulative effect of the transactions to determine whether they circumvent the underlying policy of the Act, which clearly prohibits the deduction of personal mortgage interest for tax purposes.

The only absolute in tax planning is that legal form prevails over substance, except in those circumstances where a court determines that substance prevails over form.

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