TAX ANGLES A matter of interest for investors

All resourceful investors know the advantages of having the interest expense on borrowed funds deductible for income tax purposes. The actual out-of-pocket cost is thereby reduced by tax relief at marginal rates. Having just completed their tax returns they know that marginal tax rates have become appallingly high.

The basic rule is that interest is deductible in computing income if it relates to borrowed funds that are used for the purpose of earning income from a business or property. Thus if borrowed funds that are used to purchase a common share which may (not will but may) give rise to dividend income, the interest is deductible. If the share appreciates in value, and the investor realized the capital appreciation, the ability to deduct the interest expense on funds borrowed to acquire the share substantially enhances the after-tax re turn. If the share declines in value, the ability to deduct the interest expense on the borrowed funds helps to relieve the pain of the decline.

However, a sale of the investment at a loss, with the proceeds being insufficient to repay the borrowing, will lead to the interest expense on the remaining borrowing being not deductible. It is the current use of the funds that determines deductibility. A number of recent decisions of the courts have confirmed that where an income- producing asset was acquired with borrowed funds, the assets has been disposed of but the debt not fully repaid, the interest in the remaining debt is not deductible.

Determining interest deductibility by reference to the direct use of the borrowed funds can lead to inequitable situations. Consider the case of a young person buying a home, taking on a large mortgage. The interest on the mortgage is, of course, not deductible. Over the years, as income rises, his or her cash reserves are invested in a portfolio of securities. The result is taxable income on the securities and non-deductible interest on the mortgage. Different tax result

If instead cash reserves had been applied to pay down the mortgage, with funds borrowed to acquire the securities (these borrowings might well be secured by a mortgage on the home) the interest relating to the security purchases would generally be deductible. A slightly different approach gives a very different tax result.

A number of tax commentators, including ourselves, had concluded that if a taxpayer had non- deductible interest on personal use borrowings, and also had income- earning assets, he could make part of the interest expense deductible by: * selling the income-earning assets, * using the proceeds to pay down the personal-use debt, and * borrowing to reacquire the income-earning assets.

Of course, the tax consequences of disposing of the income-earning assets has to be taken into account. The advent of the limited lifetime capital gains exemption made this type of planning easier to undertake. Landmark case

Judicial commentary in a recent landmark Supreme Court case (the Bronfman Trust) has raised questions as to whether this procedure is in fact effective in making interest expense deductible. The chief justice commented that if the sale of assets, the use of the funds for non-income-earnings purposes and the borrowing to reacquire assets all took place within a brief period of time, the court might consider the transactions a sham designed to conceal the essence of the transaction, namely the use of borrowed funds for non-income-earning purposes. In light of these comments, clearly some care has to be taken in undertaking this type of tax planning. In particular, the assets acquired with the newly-borrowed funds should be sufficiently different from the assets originally held that it is clear there has been an economic change.

There has been some speculation that the impending Canadian tax reform will introduce additional limits on the deductibility of interest on borrowed funds. It has been noted that the deduction for interest on funds borrowed to acquire shares combined with the limited lifetime capital gains exemption (that encompasses gains on the sale of shares) provides investors with a significant tax preference. Will Canadian tax reform follow the U.S. example and impose an arbitrary limit on the amount of otherwise deductible interest t hat may be claimed against income not related to the interest expense? If so, what sort of transitional rules will apply to borrowing arrangements in place prior to the implementation date? We will have to wait until the release of the tax reform white paper, now promised for June 18, to find out what the government has in mind in this respect.

Resourceful investors who are contemplating using borrowed funds for investment purposes in the near future may wish to ensure the transactions are carried out prior to June 18, in the expectation that there will be some transitional relief if the rules relating to the deduction of interest are changed.