Tax & Accounting April 26, 2018

Investor loses interest deduction by using returns of capital from mutual fund for personal purposes

Eric Van Steenis v. The Queen (2018 TCC 78), a recent Tax Court of Canada decision, is an example of where return of capital (“RoC”) distributions from a mutual fund can disallow a portion of an investor’s interest deduction with respect to the investment in that fund. The Eric Van Steenis (“the appellant”) borrowed $300,000 to purchase units of a mutual fund. From 2007 to 2015, the appellant received a total of $196,850 of RoC distributions from the fund, and more than half of that total RoC was used for personal purposes. Regardless of this, the appellant claimed a full interest deduction under s. 20(1)(c) with respect to the entire loan outstanding each year.  The CRA reassessed the appellant for 2013, 2014, and 2015 and denied a large portion of the interest deductions claimed because the borrowed money was no longer being used for the purpose of gain or producing income. Disputing the Direct Use of the Borrowed Money At a high-level, an interest deduction from income from a business or property under s. 20(1)(c) is allowed  where the following conditions are met:
  1. the amount is paid or payable in respect of the year;
  2. the amount is paid pursuant to a legal obligation to pay interest on borrowed money;
  3. the money is used for the purpose of earning income from a business or property; and
  4. the amount is reasonable.
The main dispute of this case whether the appellant continued to meet this purpose test (third condition). Jurisprudence provides that there must be a direct link between the borrowed money and a current eligible use of the money. The appellant argued that the money continued to be used for the eligible purpose because he continued to hold the same units originally purchased throughout the entire period. However, the Judge took what I think is the more commonly-accepted stance: where RoC distributions are received and used for non-income-earning purposes, the direct link between the borrowed funds and the mutual fund units disappears. As a result, the appeal of the Minister's assessment denying the majority of the appellant's interest deduction was dismissed. A Cautionary Tale for Investors If RoC distributions are reinvested in the mutual fund or another income-earning investment, there should not be any cause for concern since the direct use remains to be for the purposes of earning income from property. But where an investor borrows to invest in a mutual fund and plans to use the distributions for personal reasons (e.g., to pay living expenses), investment advisors should be prepared to educate them on how the tax attributes (RoC specifically) can affect their interest deduction. Unfortunately, it is difficult for tax preparers to be on the lookout for deadly combo that is interest deductions and RoC. It is my understanding that although the RoC information is available to mutual fund investors when they access the tax attributes of a mutual fund’s distributions (i.e., on the fund company’s website), fund companies are not required to include RoC on the T3/T5 slips, which is likely the only tax attributes tax preparers use when filing a return.
Cameron Mancell
CFP®, Senior Technical Writer at Wolters Kluwer Canada
Cameron Mancell, CFP®, is a Senior Technical Writer at the Wolters Kluwer office in Toronto. Cameron contributes to Canadian Tax Reporter, Preparing Your Income Tax Returns, and Preparing Your Corporate Income Tax Returns, among several others.
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