Whether interest on T-series distributions is or is not deductibleBy Doug Carroll | September 18 2018 07:00AM
Borrowing money for investment is a way to leverage up the amount of capital on which you can generate income. Of course that can also work against you by magnifying losses, but whichever way the performance goes, the interest on that borrowed money is usually tax-deductible.
For a straight buy’n’hold investor, deductibility is in turn straightforward. But when the borrowed money is repositioned in some way – whether by the investor’s actions or by the operation of the investment itself – deductibility can be brought into question.
Mutual funds – return of capital
In Van Steenis v. The Queen, the taxpayer borrowed $300,000 in 2007 to invest in units of a mutual fund. The fund had the capacity to return capital to investors, a feature often called ‘tax-efficient’ or t-series funds. In this case, the fund returned capital each year up to 2015, to a total of $196,850. Mr. Van Steenis used some of that money to pay down his loan, but the majority was used for personal expenses.
The Canada Revenue Agency reassessed Mr. Van Steenis for his interest expense deductions from 2013 to 2015, denying the portion related to his personal expenses.
Requirements for interest deductibility
As background, there are four requirements for interest deductibility:
- interest must be paid or payable in the year.
- it must be pursuant to a legal obligation on the borrower to make the payment,
- the money must have been borrowed for purpose of earning income from a business or property, and
- the amount of interest must be reasonable.
Importantly on the third point, it is the current use of borrowed money that is relevant in determining the income-earning purpose. On appeal, Mr. Van Steenis’ position was that he borrowed the money in 2007 to purchase mutual fund units, and that he continued to own those same fund units in the years in question, so therefore he should be entitled to continuing interest deductions.
Furthermore, he had no control over how the fund company characterized the distributions. He argued that though the fund was returning capital from its perspective, that does not necessarily correlate with each unitholder’s actual invested capital, and therefore he should not be bound by that characterization.
Ruling on continuing purpose
The judge did not accept Mr. Van Steenis’ arguments. Almost two-thirds of his capital was returned to him over the years, and more than half of that was used for personal purposes. Returning to that third deductibility requirement, there was no longer a direct link between the borrowed money and investment in the fund units.
In support of this finding, the judge points to the fact that a mutual fund trust is by its nature a flow-through structure. Income that it distributes to unitholders is included in their income and deducted from the fund’s income. By contrast, capital distributions result in a dollar-for-dollar reduction in the unitholder’s adjusted cost base, according to specific provisions of the Income Tax Act.
In sum, a return of capital reduces the amount of the investor’s own money that is in fact invested. If the entire returned capital had been used to reduce the borrowed principal, all ongoing interest charges would have been deductible because all remaining outstanding indebtedness would still be directly connected to the fund units.
As it was, more than half of that money was spent on personal expenses, and you don’t get a deduction for personal spending.