Leveraging, or borrowing to invest, can be a very effective strategy. When an investor believes his or her potential return on an investment will exceed the cost of borrowing, leveraging can make sense. The benefits are further enhanced when interest paid on borrowed money is taxdeductible over the course of the leveraging strategy.
Section 20(1)(c) of the federal Income Tax Advisor to Client (Keyword) Act (ITA) states that interest on borrowed money is taxdeductible if it is paid or payable in the year, and the borrowed money was used for the purpose of earning income from a business or property. In this context income does not include capital gains, but business income, interest, dividends, rents and royalties would normally qualify.
Provided the property has the potential to pay income, the cost of borrowing should be taxdeductible. This is generally the case for stocks, bonds, segregated funds and mutual funds. Interest deductibility normally ceases when borrowed money is no longer invested in a business or property that has the potential to earn or pay income.
In an effort to provide cash flow, some investments distribute return of capital (ROC) to investors. One such investment is “Series T” mutual funds which typically aim to distribute a certain cash flow each year (i.e. 5%, 6%, 7%, etc.) while attempting to achieve growth at a rate that is equal to, or greater than, the distribution.
While the distribution may consist of interest, dividends or capital gains, a large portion is often taxfree ROC, which represents a return of your investor’s original capital. Taxfree ROC can be an efficient form of income for many investors, including retirees who may be concerned about reductions to incomesensitive old age security benefits.
Since many Series T mutual funds have the potential to pay income (i.e. interest or dividends), interest paid on borrowed money used to invest in these funds is generally taxdeductible. The question is, given that ROC payments represent a return of an investor’s capital, if the capital is sourced from borrowed money, how long will interest remain deductible if ROC payments are received on an annual basis?
Canada Revenue Agency (CRA) income tax interpretation bulletin IT533 says interest on borrowed money is taxdeductible where there is a “link between the money that was borrowed and its current [eligible] use.” A separate CRA technical interpretation (20070236351E5) states that “it is the current use made of the borrowed money in a particular year rather than the original use of the money, which must be considered in determining whether the interest paid or payable with respect to the borrowed money is deductible in the particular year.”
In other words, to determine if interest remains deductible on a loan used to invest in ROCpaying securities, it is necessary to determine the current use of the borrowed money. This is generally referred to as the ‘tracing principle.’ Consider the following example:
Kim, Bill and Steve each borrow $50,000 from their local bank at a 3% interest rate. Each of them invests the borrowed money in a Series T mutual fund. The mutual fund has the potential to pay dividend income, so an interest deduction is available in respect of the borrowed funds. At the end of year one, Kim, Bill and Steve each pay $1,500 of accrued interest on their loans. They also receive $3,500 in cash distributions from their respective mutual funds consisting of $500 of dividend income and $3,000 of ROC.
Assuming the same distribution is received each year, Kim, Bill and Steve spend the $500 dividend on personal items each year. The ROC, on the other hand, is spent differently by each of them. Kim spends her $3,000 ROC payment on vacations each year. Bill uses his ROC distribution to repay his loan. Steve reinvests his ROC payments in incomeproducing securities. How does the use of their ROC payments impact the deductibility of interest each year?
According to the CRA documents referenced above, it is necessary to identify the current use of borrowed money to determine the extent to which interest remains deductible. For Kim, Bill and Steve, throughout the first year of their investment period the entire loan remained invested in an eligible investment which allowed for full deductibility of interest payments. Details at the end of year one can be summarized as follows:
Kim (spend ROC)  Bill (repay loan)  Steve (reinvest ROC)  
Outstanding loan^{1}  $50,000  $50,000  $50,000 
Amount on which interest remains deductible^{1}  $50,000  $50,000  $50,000 
Dividend  $500  $500  $500 
ROC  $3,000  $3,000  $3,000 
Interest payable (A)  $1,500 ($50K x 3%)  $1,500 ($50K x 3%)  $1,500 ($50K x 3%) 
Interest Deduction (B)  $1,500($50K x 3%)  $1,500 ($50K x 3%)  $1,500 ($50K x 3%) 
Nondeductible amount (AB)  $0  $0  $0 
^{1}Before distribution
Once paid, the $500 dividend payment can be spent in any way without impacting interest deductibility. Because the dividend is not “original capital” it is not considered borrowed money and may therefore be used for any purpose. ROC, on the other hand, is considered original capital and would impact interest deductibility if its current use cannot be linked to a property that has the potential to pay income. Given the different ways in which Kim, Bill and Steve spend their ROC distributions, details at the end of year two can be summarized as follows:
Kim (spend ROC)  Bill (repay loan)  Steve (reinvest ROC)  
Outstanding loan^{1}  $50,000  $47,000  $50,000 
Amount on which interest remains deductible^{1}  $47,000  $47,000  $50,000 
Dividend^{2}  $500  $500  $500 
ROC^{2}  $3,000  $3,000  $3,000 
Interest payable (A)  $1,500 ($50K x 3%)  $1,410 ($47K x 3%)  $1,500 ($50K x 3%) 
Interest Deduction (B)  $1,410 ($47K x 3%)  $1,410 ($47K x 3%)  $1,500 ($50K x 3%) 
Nondeductible amount (AB)  $90  $0  $0 
^{1}Before distribution
^{2}Assumes fair market value of investment remains at $50,000 and dividend and ROC payments remain the same each year
While Kim’s interest payment remained at $1,500 at the end of year two, the deductible portion of this payment was reduced to $1,410, a difference of $90. This treatment reflects the fact that, for interest deductibility purposes, the current use of Kim’s loan is no longer fully linked to an eligible investment. Because Kim’s ROC was used for personal purposes, interest on that portion of the loan is no longer taxdeductible. This would typically occur if Kim’s ROC payment was used to pay interest on the loan, as interest is generally considered a personal use expense.
Bill’s interest deduction also decreased, but so did the amount of interest that was payable. Because Bill’s ROC distribution was used to reduce the principal amount of his outstanding loan, he incurred less interest costs, and his entire interest expense remained fully taxdeductible.
By remaining fully invested, Steve’s $1,500 interest payment continued to be fully taxdeductible.
Continuing with this example, year three of the investment period is summarized in the chart below. Once again you’ll notice a difference ($180) between the amount of interest Kim paid and the amount she is able deduct for the year – a difference resulting from her personal use of ROC:
Kim (spend ROC)  Bill (repay loan)  Steve (reinvest ROC)  
Outstanding loan^{1}  $50,000  $44,000  $50,000 
Amount on which interest remains deductible^{1}  $44,000  $44,000  $50,000 
Dividend^{2}  $500  $500  $500 
ROC^{2}  $3,000  $3,000  $3,000 
Interest payable (A)  $1,500 ($50K x 3%)  $1,320 ($44K x 3%)  $1,500 ($50K x 3%) 
Interest Deduction (B)  $1,320 ($44K x 3%)  $1,320 ($44K x 3%)  $1,500 ($50K x 3%) 
NonDeductible Amount (AB)  $180  $0  $0 
^{1}Before distribution
^{2}Assumes fair market value of investment remains at $50,000 and dividend and ROC payments remain the same each year
Assuming Kim continues to spend her ROC distributions on personal use items, her interest deduction will continue to decrease, making her leveraging strategy less and less effective over time.
For clients who understand the potential benefits and risks of leveraging, borrowing money to invest can help accumulate assets. Where borrowed money is used to invest in securities that pay ROC (whether through Series T distributions or other types of ROCpaying investments or as part of a systematic withdrawal plan that returns capital as part of its cash flow), it is important to understand how ROC impacts interest deductibility. Armed with this information, financial advisors are in a position to help clients plan for the use of their distributions.
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DAVID.BRADY.1
Re: interest deductability; what happens if the investments have consistently lost money since purchased in a leveraged loan program and not paid any distributions. If the investment is sold, wob’t the loss be considered a capital loss? What is the tax effect?
Tuesday, November 27 @ 5:01 pm //////