It really pays to know the rules – regardless of what game or activity you’re involved in. And this is no truer than in the world of tax planning. I’d like to share the story of a taxpayer who was handed a decision at the Tax Court of Canada (TCC) just two weeks ago that cost him.
On April 20, the TCC handed down its decision in the case of Van Steenis v. The Queen. In this story, Eric Van Steenis had borrowed $300,000 to invest in a mutual fund. He then deducted his interest costs in each of his tax years from 2007 to 2015 for all the interest he paid on those borrowed dollars.
Throughout those years, Mr. Van Steenis received distributions from his mutual funds that were a return of capital – a total of $196,850. He used these cash distributions partly to pay down the debt owing, but used most of the cash for personal purposes. The taxman reassessed him and denied a portion of the interest deductions he claimed on the basis that the borrowed funds were no longer used solely for the purpose of earning income. Mr. Van Steenis appealed the decision and lost the case. This comes as no surprise to Canadian tax geeks everywhere.
The rules around interest deductions can be complicated, but there are some general principles that apply here. To start, you’re generally allowed to deduct interest on borrowed money where the purpose (call this the “purpose test”) of the borrowing was to earn non-exempt income from a business or property. Income from “property” includes interest income, dividends, rents and royalties. So, borrowing to invest in a mutual fund or other securities that will provide some taxable income should do the trick.
Where did things fall apart for Mr. Van Steenis? In addition to a purpose test, there’s the “direct use” test. This test requires that you examine the current direct use of the borrowed money. Mr. Van Steenis received some of his capital back from the mutual fund. If he had reinvested this to produce income, he would have been able to continue deducting his interest. But he didn’t. He used much of that capital for personal spending. So, some of the borrowed money could no longer be traced to an income-earning purpose.
Earning income from business or property is important to deducting your interest costs. Be aware that capital gains don’t count as income from property.
Also, earning income with the borrowed funds simply needs to be one of your purposes; it doesn’t have to be your main purpose for borrowing the money. And it’s not critical that you earn “net income” or “profits” when borrowing to invest. That is, the federal interest deductions you claim over time might be higher than the income you earn from the borrowed money – and that’s okay. This position was confirmed by the Supreme Court of Canada in the Ludco decision in 2002, and again by the Canada Revenue Agency in its Income Tax Folio S3-F6-C1, Interest Deductibility (see paragraph 1.27; this Income Tax Folio is available online and is worth reading if you want to learn more about interest deductibility.
If you’re a resident in Quebec, where the rules are a little different, the interest you deduct in any given year cannot exceed the investment income you earn in that year (investment income in this case includes the taxable half of capital gains along with other income from property).
Finally, if Mr. Van Steenis had lost all or most of his capital because his investments had declined in value, he’d still be able to deduct his interest (this is called the “disappearing source” principle). But it’s not okay to change the use of the borrowed money from an income-producing use (the mutual fund investment) to being used for personal expenditures.
Tim Cestnick, FCPA, FCA, CPA(IL), CFP, TEP, is an author, and co-founder and CEO of Our Family Office Inc. He can be reached at email@example.com.