Interest deductions a reasonable tax strategy, but it can get technical

INTEREST RATE DEEMED TO BE UNREASONABLE 10%

Most investors who borrow money for the purpose of investing are counting on their ability to deduct that interest expense for tax purposes. Absent the tax deduction, the leveraged investment may not make financial sense. But you have to be careful when it comes to interest deductibility, because it may be denied if you don’t follow the technical requirements.

Under the Income Tax Act, if you borrow money for the purpose of earning investment or business income, the interest you pay on that debt is generally tax deductible. Previously, the Supreme Court of Canada articulated the four requirements that must be met in order for interest to be tax deductible. First, the amount must be paid (or payable) in the year. Second, it must be paid pursuant to a legal obligation to pay interest on borrowed money. The borrowed money must also be used for the purpose of earning income from a business or property and, finally, the amount of interest paid must be reasonable.

But what exactly is a “reasonable” rate of interest? A new Canada Revenue Agency warning about certain tax-free savings account (TFSA) schemes along with a recent Quebec tax case shed some light on when a claim for interest expense may be deemed unreasonable by tax authorities and, thus, not tax deductible.

TFSA maximizer schemes

Earlier this month, the CRA issued a warning to Canadians about participating in tax schemes where promoters claim that investors can transfer funds out of their registered retirement savings plan (RRSP) or registered retirement income fund (RRIF) into a TFSA without paying taxes and without any regards to the annual TFSA contribution limit.

Typically, the scheme is marketed to sophisticated investors who have large balances in their RRSP (or RRIF) and TFSA, as well as significant equity in their personal residence. The promoter operates a special-purpose mortgage investment company (MIC) that only “invests” in mortgage loans to scheme participants. The MIC issues two classes of shares: one pays dividends at a low rate and the other pays dividends at a much higher rate.

The investor buys the low-dividend shares of the MIC in their RRSP (or RRIF) and the high-dividend shares in their TFSA. The MIC then lends the share proceeds back to the investor in the form of a first and a second mortgage, secured by the investor’s personal residence and TFSA balance. The rates on the loans correspond to the dividend rates on the two classes of MIC shares.

The investor then invests the loan proceeds with the promoter and earns taxable investment income. The investor makes annual taxable RRSP (or RRIF) withdrawals and claims a fully offsetting interest deduction relating to the interest expense on the loans, which is significant.

The result is that after several years of participating in the scheme, the investor is supposedly able to shift their entire RRSP (or RRIF) balance to their TFSA in a way that the promoter claims is “tax free” and is not subject to the annual TFSA contribution limit.

Of course, the key assumption to make this strategy work is that the promoter claims that the high interest rate paid on the second MIC loan, typically 15 per cent, is “normal” for second residential mortgages and explains the corresponding high dividend rate on the second class of MIC shares.

According to the CRA, however, the entire arrangement is “commercially unreasonable,” because the lender’s actual credit risk is low since the investors are all “wealthy participants in the scheme who are unlikely to default” on their own mortgages. In addition, the second high-interest-rate mortgage (15 per cent) is secured by both the participant’s residence and growing TFSA balance. According to the CRA, “the high rate of interest on the second mortgage and the high dividend rate on the second class of shares are not justified as the participants are essentially borrowing from themselves.”

As a result, the CRA said the interest paid on the MIC loan may not be fully deductible since the rate is not reasonable and, more significantly, any increase in the value of the investor’s TFSA would be considered an advantage subject to the 100-per-cent advantage tax.

The Quebec case

The reasonability of an interest expense deduction also recently came up in a Quebec Court of Appeal case. A corporate taxpayer operates a large used car dealership that is owned by three brothers through their respective holding companies. To finance the operations, the shareholders loaned $6 million to the dealership at an annual interest rate of 10 per cent. The dealership paid interest on the loans and deducted the interest for Quebec provincial tax purposes.

Revenu Québec audited the corporate taxpayer and initially felt that the appropriate rate of interest to be used on the loan should be three per cent, based on the Bank of Canada’s prime lending rate at the time.

The taxpayer argued that 10 per cent was reasonable, providing a letter from its bankers stating that the effective interest rate for financing unsecured vehicle inventories under cash flow deal loans was between nine and 12 per cent. The taxpayer also provided a report by Deloitte that concluded a “reasonable rate” of interest for an equivalent loan would be between 7.89 and 12.39 per cent.

Revenu Québec then reassessed the taxpayer on the basis that the correct rate to be used for the interest deduction was 7.89 per cent, and the trial judge agreed. The taxpayer appealed this decision.

The appellate court disagreed and reversed the lower court’s decision. The government’s position was that the interest rate of 10 per cent was unreasonable. But since the taxpayer was able to provide two independent sources, namely the bank and Deloitte, to back up its use of that rate, the court concluded that the taxpayer had “demolished” the government’s assumption that this rate was unreasonable and concluded that the interest expense was appropriately deductible.

As tax lawyer James Trougakos of Davies Ward Phillips & Vineberg LLP in Montreal wrote in a recent case note: “Given that reasonability often falls within a spectrum, tax authorities should not be permitted to reassess simply because they believe that a taxpayer’s deduction, while reasonable, could have been lower.”