A cautionary tale on interest deductibility
Interest paid on borrowed funds — be it a margin account, an investment loan or a line of credit — where the purpose of the funds is to earn investment income, is generally tax deductible.
Clients who borrow to invest in mutual funds, however, could be tripped up on their interest deductibility if the funds pay out distributions in the form of return of capital (“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 ROC 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 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 Federal Court of Appeal (“FCA”) decision (Van Steenis v. Canada, 2019 FCA 107) upheld a 2018 decision of the Tax Court of Canada with respect to interest deductibility. In the case, the taxpayer 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 totaled $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% of the interest he 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.”
In the case, the Court had to decide whether 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 that a link existed since the money was borrowed for the purpose of buying the mutual fund units. He maintained that since he continued to own 100% 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 lower court 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% 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.
The recent confirmation by the FCA of the lower court ruling serves as a cautionary tale to any investors who are writing off interest on their mutual funds that distribute ROC.