Borrowing to invest in mutual funds
The ability to write off interest expense when borrowing for the purpose of earning investment income is critical in many investment and insurance strategies. Yet, investors can sometimes get confused by more complex leveraged investments and, in some cases, jeopardize future deductibility if they are not careful.
Two recent technical interpretations released by the Canada Revenue Agency (CRA) shed some light on a couple of situations in which the continuing ability to write off interest expense on an investment loan has come into question in the context of borrowing to invest in mutual fund investments.
In a technical interpretation (2007-0230431E5) dated August 23, 2007, the CRA was specifically asked whether interest on money borrowed to invest in mutual fund trust units continue to be deductible following an income distribution paid to the investor in cash.
The CRA responded, not surprisingly, that since the current use of the borrowed money remains unchanged as none of the units originally acquired with the borrowed funds was disposed of, interest on the borrowed money would continue to be tax deductible.
Reinvested distributions, subsequent redemption
Now, what if instead of receiving cash distributions the investor chose (or, in some cases, was actually required) to automatically reinvest the distributions in additional units of the fund. The investor then subsequently sells exactly the same number of mutual fund trust units as were purchased through the reinvestment of the distribution. Would the interest on the loan used to acquire the original mutual fund units continue to be 100 per cent tax deductible?
This scenario was also discussed in the same technical interpretation. The CRA responded that, since the part of the original investment has actually been disposed of, interest on the borrowed money that was used to acquire that original investment would only continue to be deductible if the portion of the funds redeemed is reinvested in another income-producing investment.
To illustrate, let's say Sal borrows $100,000 to invest in 100,000 units of a mutual fund. At the end of the year, the fund distributes $3,000 of income, which is immediately reinvested in an additional (assumed) 3,000 units of the fund. Sal then disposes of 3,000 units.
Using the "proportional method", which is required under Canadian tax law, since you can't specifically identify which units were sold (all units being identical and not being permitted to use a "first in, first out: (FIFO) or "last in, first out"(LIFO) methodology for Canadian tax purposes), the 3,000 units disposed of consist partially of units originally purchased and partially of those purchased by reinvesting the distribution.
As a result, only 97.09 per cent (100 per cent - (3,000/103,000)) of the total amount originally borrowed continues to be invested in the fund, while 2.91 per cent has been disposed of. If the proceeds are used to pay down a portion of the original loan, the interest on the remaining loan balance would continue to be 100 per cent deductible.
Similarly, if the proceeds are used to invest in another income-producing investment, the interest on the full borrowing would continue to be deductible. On the other hand, if the proceeds are used for personal purposes, only interest on 97.09 per cent of the original borrowing would continue to be deductible.
ROC mutual funds
A similar issue arises when borrowed funds are used to purchase a "return of capital" or ROC mutual fund. These funds are designed in such a way that all (or nearly all) of their monthly distributions consist of ROC.
This is generally tax advantageous since ROC is not currently taxable but rather reduces the investors' adjusted cost base (ACB) of the mutual fund investment, generally resulting in a deferred capital gain when the fund is ultimately sold.
Where in prior years investors (and perhaps the CRA) may have "overlooked" ROC in calculating their ACB, in 2004, the CRA introduced a new requirement for fund companies to report any ROC distributions received in Box 42 of the T3 information slip sent annually to mutual fund investors.
In another recently released technical interpretation (2007-0236351E5), the CRA was specifically asked whether interest on money borrowed to invest in ROC mutual fund units continue to be deductible following a return of capital.
The CRA responded that, where ROC is distributed to the unit holder (without any disposition of any portion of the investment), "it would be appropriate to consider that the income-earning purpose of the original borrowed money may no longer be met with regard to such returned capital".
As a result, unless the ROC distributions are reinvested either in the same fund or in another income-earning investment, the interest on the portion of the borrowed money that relates to the ROC distribution would no longer be tax deductible since it's no longer being used for an income-earning purpose.
To illustrate, if $100,000 was borrowed to invest in a ROC mutual fund that distributes six per cent ROC at the end of the year that is not subsequently reinvested in an income-earning investment, in the second year, only 94 per cent (($100,000 - $6,000) / $100,000) of the interest expense paid on the loan would continue to be tax deductible.