The interest expense when you borrow money, either through your margin account, an investment loan or a line of credit, and use it for the purpose of earning investment income is generally tax deductible.
This tax deduction is important since it can dramatically reduce your true, effective after-tax cost of borrowing. For example, if you live in Nova Scotia, and you pay tax at the top combined federal/provincial marginal tax rate of 54 per cent, your tax cost of borrowing $100,000 for investment purposes, using a secured line of credit at bank prime rate (currently around 3.45 per cent), is only $1,587 annually, assuming the interest is fully tax deductible.
But if you invest the loan proceeds in mutual funds, your tax calculations may become a bit more complicated depending on the type of distributions you receive and whether those distributions are reinvested.
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Mutual fund investors typically receive distributions monthly, quarterly or annually. These distributions can consist of the fund’s net income (Canadian dividends, foreign income or other income) or capital gains, but sometimes they are classified as a “return of capital” or ROC, which typically arises when a fund distributes more cash than its income and realized capital gains in a particular year.
Any ROC distribution is not immediately taxable, but it reduces the adjusted cost base (ACB) of the units held, thus generally increasing the amount of capital gain (or reducing the capital loss) that will be realized when the units are redeemed. The amount of any return of capital is shown in Box 42 of the T3 information slip.
If the total amount received as a return of capital ever exceeds the investor’s ACB of the units acquired (increased, naturally, for any reinvested distributions), the tax rules deem the excess (the negative ACB) to be a capital gain, which must be included in the investor’s income for the year in which the excess arose.
A recent decision of the Tax Court, released in late April, concerned a taxpayer who borrowed $300,000 to purchase units of a mutual fund. Each year from 2007 to 2015, the taxpayer received a return of capital from the fund, which totalled $196,850 over those years.
The taxpayer used some of the ROC to reduce the outstanding principal of his loan, but used the majority for personal purposes. Each year on his return, the taxpayer deducted 100 per cent of the interest paid on the loan.
The Canada Revenue Agency reassessed his 2013, 2014 and 2015 tax years to deny a portion of the interest deducted, saying the taxpayer was not entitled to deduct interest relating to the returns of capital that had been used for personal purposes, “as the money borrowed in respect of those returns of capital was no longer being used for the purpose of gaining or producing income.”
Under the Income Tax Act, interest is deductible if “paid on borrowed money that is used for the purpose of gaining or producing income.”
Years ago, in a seminal decision, the Supreme Court of Canada summarized the four requirements that must be met for interest expense to be tax deductible: “(1) the amount must be paid in the year …; (2) the amount must be paid pursuant to a legal obligation to pay interest on borrowed money; (3) the borrowed money must be used for the purpose of earning non-exempt income from a business or property; and (4) the amount must be reasonable.”
In the recent case, the Tax Court had to decide whether, under the third requirement, there was “a sufficient direct link between the borrowed money and the current use of that money to gain or produce income from property.”
The taxpayer argued this requirement had been met since the money was borrowed for the purpose of buying the mutual fund units. He maintained that since he continued to own 100 per cent of the units, “his current direct use of the borrowed funds is still (the) … same … (and) … that he is therefore entitled to deduct all of the interest payments on those funds.”
The judge disagreed, finding that almost two-thirds of the money that he invested over the years was returned to him and more than half of that returned money was put to use for personal purposes. As the judge wrote, in the tax years under review, “that was its current use. As a result … there was no longer any direct link between those borrowed funds and the investment.”
The judge distinguished between income distributions and a return of capital, saying the taxpayer would have continued to be able to deduct 100 per cent of his interest payments if he had received income distributions that he used for personal purposes.
In other words, unless ROC distributions are reinvested in either the same fund or another investment, the interest on the portion of the borrowed money that relates to those distributions would no longer be tax deductible since the funds are no longer being used for an income-earning purpose.
To illustrate, if you borrow $100,000 to invest in a mutual fund that distributes a six-per-cent ROC at year-end that is not subsequently reinvested in an investment, only 94 per cent of the interest expense paid on the loan in the second year would continue to be tax deductible.