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Interest deductions lost under proposed law

What do you get when you turn two old ranchers into cabinet makers? Downright ugly furniture -- that's what. No matter, Tom and Jack Musser, ages 81 and 84 respectively, of Delta, Colo., are making money selling their one-of-a-kind crooked furniture to collectors.

The brothers, who together don't weigh as much as one Marlboro man, gave up ranching and took up woodworking after Tom had an accident in 1992 and "stove up" his back. They took no classes at Home Depot, didn't read any books or watch This Old House. In the words of one satisfied customer, the Mussers aren't "burdened with any knowledge of woodworking." "We just do what the sticks want," Tom told Nancy Lofholm of The Denver Post.

Who knows, maybe Tom and Jack are actually skillful craftsmen who deliberately make a ludicrous final product to make money. Hmm. Sounds like the lawmakers at the Department of Finance. Skillful at crafting tax law? Sure. But they can be accused of some pretty shady craftsmanship recently, with the result being a ludicrous proposed change to our tax law that could cost Canadians thousands of tax dollars.

The proposal

Canadian tax law has always allowed a deduction for interest costs where the borrowed money is, among other uses, used to earn income from property (which includes interest, dividends, rents or royalties -- but not capital gains). But our tax law doesn't explain what is meant by "income."

In the case of Ludco Enterprises Ltd. v. Canada, the Supreme Court of Canada (SCC) ruled that "income" means "gross income," not "net income." In other words, you should be able to deduct interest costs where you borrow money to earn income from property, even if the income you expect to earn does not exceed the interest costs you incur on the borrowed money. All that matters is that you earn some income.

The government apparently didn't like the decision in Ludco. On Oct. 31, 2003, the Department of Finance released proposed changes to Canadian tax law that will generally deny interest deductions to just about any investor borrowing to invest in common shares, mutual funds, or many other marketable securities. How so? Proposed subsection 3.1(1) says that it must be reasonable to expect that the investor will realize a cumulative profit over the period of owing the investment before a deduction can be claimed for interest costs in excess of income from the investment.

Did you catch that? If your interest costs are likely to be greater than the interest, dividends, rents, or royalties you expect to earn on the investment over the period of ownership, you won't be able to claim the excess interest costs as a deduction.

Now, let's do the math here. Say you borrow money at 5 per cent to invest in common shares. How much in dividends can you expect annually? Say, 2 per cent. Pretty realistic. In this case, 3 per cent of your interest costs would not be deductible annually under proposed subsection 3.1(1). Ludicrous? Absolutely. After all, you'll face tax on any capital growth on those shares over the long run, but unlike U.S. tax law, our tax law disregards capital gains when measuring "income from property."

The conflict

Interestingly, the Canada Customs and Revenue Agency (CCRA) released its new bulletin IT-533 on this issue on the very same day that Finance issued this proposed change to the law. Coincidence? Hardly. Here's the problem: The CCRA announced something very different than the Department of Finance.

While Finance wants to ensure that "income" under our tax law means "net income" (that is, you must have more income from the investment than interest expense to be entitled to a full interest deduction), the CCRA has adopted the position of the Supreme Court of Canada in the Ludco case, and is only insisting that you earn some income.

Is it possible that Finance and the CCRA were mixed up about what the other was going to announce? No chance. Our government has said that it intends to allow the deductibility of interest costs related to borrowed money invested in common shares and the like (Finance explicitly said this in the Oct. 31 press release, and CCRA said the same in IT-533, paragraph 31), but has worded the proposed law to deny or restrict interest deductions. In other words, our government is saying "we're going to reserve the right to deny interest deductions, but don't worry, we won't enforce the new law."

Folks, welcome to Canada -- the new home of Third World tax law. The only good news is that Finance has received plenty of negative feedback on the proposed law. Stay tuned, more is sure to come.

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