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The ability to write off interest expense for tax purposes is often critical to the success (or failure!) of leveraged investment plans. 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 investors need to be careful when it comes to interest deductibility because if they don’t follow the technical requirements, the interest deduction may be denied.

The general rule

Under the Income Tax Act, investors who borrow money for the purpose of earning investment or business income can deduct the interest they pay on that debt for tax purposes. 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. In addition, the borrowed money must 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 sheds some light on when a claim for interest expense may be deemed unreasonable, and thus not tax deductible, by the tax authorities.

TFSA maximizer schemes

In May, 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 tax-free savings account (TFSA) without paying taxes and without any regard to the annual TFSA contribution limit.

Typically, the scheme is marketed by promoters to sophisticated investors who have large balances in their RRSP (or RRIF) as well as in a TFSA, and significant equity in their personal residence. The promoter operates a special-purpose mortgage investment company (MIC) that “invests” only 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 making this strategy work is that the promoter claims that the high interest rate paid on the second MIC loan, typically 15%, 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” since the lender’s actual credit risk is low because 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%) is secured both by the participant’s residence and by the 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 says that the interest paid on the MIC loan may not be fully deductible as 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% advantage tax.

So, the next time a client approaches you about a TFSA scheme that sounds just too good to be true…it is!