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Interest Deductibility

Taxpayers win interest-deductibility cases.

Taxpayers win interest-deductibility cases.

Used to losing arguments over expense deductions, taxpayers celebrated two significant Supreme Court victories.

One of the American tax system’s most appealing features is deductibility of home mortgage interest from personal taxes. The Canadian government has steadfastly refused to give Canadians a similar benefit. But the Supreme Court of Canada, in one of 2 benchmark rulings, may just have given us what we want.

Singleton Case

In the Singleton case, a majority of Supreme Court judges found, first and foremost, that Canadians have a right to plan their financial affairs in a manner that minimizes their tax exposure. Second, they found that interest paid on a loan, which was part of a complex transaction including the purchase of a house, was tax-deductible.

The transaction went like this:

On October 27, 1988, John R. Singleton, a Vancouver lawyer, received $300,000 from the partnership capital account of his law firm. He used the funds to buy a house in his wife’s name.

Later the same day, Singleton borrowed $298,750 from his bank. He used this amount, plus $1,250 of his own, to pay back the $300,000 paid to him from the capital account of his firm.

He claimed the loan was being used to generate revenue in his law practice and, on his tax returns for 1988 and 1989, deducted interest of $3,688.52 and $27,415.46, respectively.

The Canada Revenue Agency (CRA) reassessed Singleton and denied the deductions. Singleton lost his first appeal in Tax Court but won at the Federal Court of Appeal. CRA then appealed to the Supreme Court and lost.

CRA’s argument was that the relative timing of fund movement from the firm’s capital account and the bank loan meant the loan was being used to finance a new house – not build the law firm’s business. Two dissenting judges agreed, saying the “economic reality” of the transaction meant Singleton had done just that.

The 5 judges who found in favour of Singleton said there was a direct link between the borrowed funds and their eligible investment in the law firm. They said timing and sequence of the cheques did not matter. Singleton had, in fact, refinanced the capital account of his firm with debt. They said he, as a Canadian taxpayer, also had the right to structure his transactions in a manner that reduced his taxes.

The implication of this ruling is that you have the right to restructure your financial affairs so that, if you can directly link borrowings to an income-earning asset, you can claim an interest deduction.

The best strategy is to buy personal assets, like a house, with your cash or invested savings and use borrowed funds for business or investment financing.

For instance, if you have equity available to you in your business or non-registered investments, use them to pay down personal debt such as your house mortgage. Use the increased equity in your house to refinance a business or investment loan. This way, interest on the loan is tax deductible.

A cautionary fly in the ointment is that the federal government may well introduce new legislation that gives it power to overturn transactions like the Singleton one. For the moment, however, the courts have said such transactions are valid.

Although tax law allows taxpayers to deduct interest on money borrowed to finance income-producing business or investments, capital gains are not considered income from investments. This was the issue disputed in the second case.

Ludco Case

In this case (known as Ludco) the Supreme Court also found in favour of taxpayers – Canadian residents who borrowed $7.5 million to invest in shares of 2 offshore companies located in a tax haven.

While they held the shares, the taxpayers deducted $6 million in interest expenses generated by the loan used to finance the share purchase. Most of the earnings of both companies were reinvested in the businesses on a tax-free basis to divert these earnings into share growth.

Only $600,000 was paid out as dividends. The taxpayers did pay tax on these dividends.

When the taxpayers sold their investment they realized capital gains of $9.2 million. CRA made the argument that interest costs far exceeded (dividend) income. Therefore, CRA claimed, the loans were used not to realize current income but to generate future capital gains. CRA disallowed the $6 million in interest costs claimed by the taxpayers.

The court agreed that the borrowed money might have had 2 purposes:

  1. To earn income
  2. To generate capital gains

The court did not agree with CRA that the $600,000 in dividends was “window dressing.” Nor did it accept the argument that the interest deducted far exceeded the income earned.

As long as dividend income was earned, no matter how little, the court said the conditions were met for deductibility of loan interest costs.

This decision is important for many taxpayers who borrow funds to invest in stocks or equity mutual funds that have modest income yield. Interest on such loans should still be deductible even if interest expenses exceed the income, as long as there is reasonable expectation of some income being generated from the investment.