Tread carefully with this tax shuffle
Interest on personal debt is not tax deductible, which is why many tax planners go through hoops to maximize writeoffs.
Much of this planning has been on hold pending the decision in the Lipson case in which a Toronto couple used a variation of the classic "Singleton Shuffle" to deduct interest.
The shuffle, named after a successful 2001 court ruling, involved a debt-swap strategy employed by many investors. It involves rearranging your financial affairs so as to make your interest on investment loans tax deductible.
The Canada Revenue Agency attacked the Lipson's interest deductions using the General Anti-Avoidance Rule. The case was heard by the Supreme Court of Canada in April and a decision is expected to be released before the end of the year.
Meantime, investors need to be cautious when it comes to deducting interest on money borrowed for investment purposes, as a recent CRA technical interpretation letter explains.
The CRA was asked whether interest on a mutual fund investment loan would be 100% deductible when the annual year-end mutual fund income distributions are automatically reinvested and the investor then sells the same number of units purchased through the reinvestment to pay the interest on the loan.
For example, assume that Jake uses $100,000 of borrowed funds to purchase 80,000 units of a mutual fund that pays a $3,000 year-end distribution. The $3,000 is automatically reinvested in 2,400 units of the fund, for a total holding of 82,400 units. Jake then sells the 2,400 units and uses the proceeds to pay the interest on the $100,000 loan.
According to the CRA, Jake must use the "proportional method" of allocating the interest expense. Since Jake sold 2,400 of 82,400 units, only 97% (i. e. 80,000/82,400) of the interest expense would be deductible because the proceeds of the 2,400 units sold were not reinvested but used to pay the interest on the debt.
To receive 100% interest deductibility, the proceeds from the sale of the units should have been used to pay down the borrowed amount or to acquire another investment, such as another fund or stock.
In other words, once an investment acquired with a portion of the original debt has been disposed of, interest on the borrowed money is deductible only if the amount borrowed can be traced to the cost of a new investment.