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:: Deductibility of interest expense against taxable income must meet stringent test
:: Last Fall I wrote an article on the deductibility of interest expense in the calculation of taxable income. I noted how this area has been in a state of limbo for over fifteen years while the minions in Ottawa try to draft workable policy to clearly deal with the issue.
To review, interest expense is generally deductible for income tax purposes under the following circumstances:
1. the interest was paid or payable in the year in accordance with a legal obligation, and
2. the borrowed funds were used for the purpose of earning income from a business or property property income being defined as interest, dividends, rents and royalties but not capital gains.
Of course, to be deductible, interest expense must also be considered reasonable in the circumstances.
Until recently, the principle of “tracing” was generally applied in the determination of interest deductibility. Following the “tracing” principle, taxpayers were required to trace the use of borrowed funds to an eligible use in order to support the deduction of interest expense in the calculation of taxable income. Tracing meant that it was the current use of the borrowed money, as opposed to the original use, that ruled the roost.
Back in 2001, a Supreme Court of Canada case introduced the concept of “linking” wherein, after considering all the circumstances, the question to be asked is whether the taxpayer had a reasonable expectation of profit at the time the investment was made. In simple terms, what this decision said was, if an income earning purpose was associated with the direct use of the borrowed funds, then interest expense should be deductible for income tax purposes.
A recent court case heard before the Tax Court of Canada highlights the importance of doing things right to maximize the advantages of tax-deductible interest expense. In the subject case, the taxpayers took out a mortgage in 1991 for $200,000 using their principal residence as collateral. The funds so borrowed were used to purchase shares in a certain company.
Generally, where money is borrowed to purchase common shares in a company interest expense is deductible for tax purposes even if the company is not in a position to pay dividends at the time of the investment. In the case at hand, the interest paid on the borrowed funds was tax deductible following either the “tracing” or “linking” principles.
Everything was chugging along just fine until the couple involved in this court case made what is in reality a common mistake. In 1996, for whatever reason, the couple decided that a new house was in order and they proceeded to take out a new mortgage for $300,000. Of this amount, roughly $162,500 was used to pay off the balance owing on the original $200,000 mortgage and the difference of $137,500 or so was applied to complete the purchase of the new home.
From that point on the taxpayers continued to view their single mortgage as, in effect, two separate loans: one for the original purchase of a share investment (a tax-deductible use) and the new, second, loan for the purchase of their new digs (not a tax-deductible use). Understanding the advantage of tax-deductible interest, the taxpayers considered the principal portion of their mortgage payments to be applied solely to the non-deductible part of their loan; interest only being paid on the tax-deductible portion of the debt. The taxpayers’ idea was sound pay interest only (no principal) on the tax-deductible debt until the non-deductible debt is paid in full it was the execution that was lacking.
Unfortunately for the taxpayers, the court concluded: (a) there was no rationale basis for the taxpayers’ proposition that because the new mortgage was obtained for two different purposes, it could be considered by the borrowers for tax purposes as two different loans; (b) that only one loan agreement was in place and payments were made against this loan as a whole; (c) that an allocation of interest expense was required to be made in each taxation year if the taxpayers were to comply with the interest deductibility provisions of the Income Tax Act, and (d) as a result, the taxpayers were not entitled to the deductions claimed.
To be clear, in the end result the taxpayers were entitled to deduct a pro rata portion of the interest paid based on the ratio (deductible vs. non-deductible) that existed when the new loan was put in place. What they were not allowed to do was consider the principal portion of their loan payments as applying solely to the non-deductible portion of their debt.
What could the taxpayers have done in this situation to accomplish their desired end, namely, an ability to focus all principal repayment on the non-deductible debt, paying interest only on the deductible debt until the non-deductible portion is fully discharged? In essence maximize their tax-deductible interest expense, minimizing the non-deductible interest in the process.
Solving the problem is actually quite simple. All the taxpayers had to do was put two distinctly separate loans in place each with the desired repayment privileges. Loan number one, replacing the original tax-deductible debt, would provide for payments of interest only; loan number two, used to purchase the new home, would be structured to allow maximum repayment of principal to enable the repayment of non-deductible debt as fast as possible.
Alternatively, the taxpayers could have established something like a home equity line of credit wherein a single mortgage is used to secure a number of distinct loans. Again payments of interest only would be made on the tax-deductible loan with larger payments being focused on the non-deductible loan.
Quoting from an earlier case, the judge noted in his reasons, “in tax law, form matters… If a taxpayer fails to take the correct formal steps, however, tax may have to be paid. If this were not so, Revenue Canada and the courts would be engaged in endless exercises to determine the true intentions behind certain transactions”. If you’re currently paying interest expense that is tax deductible, care needs to be taken if you are considering refinancing to maximize your tax advantage. Don’t get caught.
Free Tax Advice Article Submitted to Income Tax Canada.net exclusively by Jim Maroney
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