The question of interest deductions still garners much attention as the debate continues in court. Some investors believe - wrongly - that the interest they pay throughout the year can be deducted from their income.
What the Law Says
Paragraph 18(1)a) Income Tax Act (ITA) stipulates that only expenditures made or incurred by a taxpayer for the purpose of earning income are deductible. Paragraph 18(1)b) of the ITA states that a capital expenditure is not deductible unless expressly permitted by law. In a previous newsletter, we discussed this concept with regard to other expenses that may be incurred by investors.
The courts have established that the interest paid on debt is a capital expenditure. The law provides that such an expenditure may be deductible only if it meets the requirements of ITA paragraph 20(1)c). Thus, four conditions must be met for this expense to be deductible:
- The amount must be paid or payable within the year in which the taxpayer seeks to deduct it;
- The amount must be paid as a legal obligation to pay interest on borrowed money;
- The amount must be used to earn non-exempt income from a business or property;
- The amount must be reasonable, taking into consideration the first three conditions.
The third condition - which requires that the borrowed amount be used to earn income - is one that can cause confusion for some investors.
The Swirsky Case
In 2014, the decision in the Swirsky case surprised many observers, as it was the first time a decision was rendered on the deduction of interest due to the purchase of shares that had not paid dividends.
In the Swirsky decision, provided on February 7, 2014 by the Federal Court of Appeal, the court refused a taxpayer deduction for interest generated by borrowing from a financial institution to allow Ms. Swirsky to acquire ordinary shares of a family business. The Federal Court of Appeal found that the interest she had paid was not deductible because of the fact that Ms. Swirsky had no reasonable expectation that the purchase of common shares of the company would provide a profit. In reaching its conclusion, the court noted the historical absence of dividend payments.
It is not uncommon for several years to elapse before a company pays dividends to its shareholders, even though they expect this to happen one day. In the case of very large public corporations, many years may pass before any dividends are paid to shareholders. For example, despite very strong profitability, Google has not yet begun to pay dividends. Google shareholders can hope that this will happen one day but they cannot predict a specific date.
Canada Revenue Agency’s Position
Despite the foregoing, the Canada Revenue Agency, during a conference held in Montreal in October 2014, reiterated its view that the fact that a company uses all of its cash to exploit business opportunities generally does not preclude one of its shareholders from claiming a deduction for interest payable as a result of a loan used to acquire its shares.
However, the Canada Revenue Agency reserves the right to refuse an interest deduction if one cannot expect to receive dividends; when the facts and official documents clearly indicate that the permanent policy of the company is not to pay dividends on its shares.
Given the position of the Canada Revenue Agency, we recommend that investors review the securities they hold in their portfolios to ensure that the interest paid during the year can be deducted.
Capital Gain vs. Revenue
Sources of Revenue
The law provides for the taxation of various sources of income and these are subject to their own tax systems. Thus, interest or dividend income will be dealt with in accordance with sub-section b) of the ITA. This subsection provides that any expenses incurred to earn income are deductible as are related interest expenses if they satisfy the four conditions listed above.
Capital gains are taxed under subsection c) of the Act. It provides that only expenses incurred for the sale of securities will be deductible, e.g. broker commissions. There is no mention with regard to interest and other expenses that may be required to generate a capital gain.
Consequently, interest expenses are not deductible if an investor borrows money to purchase only mutual funds which have a policy of generating only capital gains.
Once again, a portfolio review is necessary. An investor should avoid holding only securities that generate capital gains, to avoid issues with the tax authorities when loans are needed to make the investments.
Additional Rules Effecting Quebec
In Quebec, interest will be deductible only if a taxpayer has earned enough income from interest, dividends and capital gains over the year. Any excess may be carried forward to future years and used when the income earned is sufficient. The information for tracking expenses that could not be deducted is listed in Schedule N of the Quebec personal income tax return.
The fact that Quebec’s limits on the interest deductions allows the consideration of capital gains in the equation does not contradict the text above. Rather, this limitation recognizes that there may be a delay between the time that interest is paid and when a dividend or capital gain is received. This measure seeks to match revenues and expenses. In any case, before being subject to this additional limit, the expense incurred to generate interest must be deductible according to the conditions above.
All taxpayers will soon have to prepare their tax return. It is therefore appropriate to review their portfolios to see if the nature of shares held personally or through a company allows the deduction of interest. In the future, it may be wise to change their portfolio’s composition to enable the full deduction of interest.
Since the levels and bases of taxation can change, any reference in this publication to the impact of taxation should not be construed as offering tax advice; as with any transaction having potential tax implications, clients should consult with their own tax advisors.