Audit Alert: Avoid Traps in Claiming Interest as a Carrying Charge

If you pay interest on money borrowed to earn investment income, you can claim a deduction for the interest paid as a carrying charge. That’s quite lucrative as the deduction offsets all other income of the year and can help to reduce net income, the figure upon which certain government benefits, like the Canada Child Benefit, are based.  But, the claim is not as straight-forward as you might think.

First, there must be a reasonable expectation that the invested funds will generate a return on the investment, in excess of the cost of borrowing the money – i.e. there must be a reasonable expectation that “income from property” can be from the investment. This means that the investment has the potential to earn interest, dividends, rent or royalties, which will be reported as income on the tax return. Despite the deduction, if you borrow money at 6% to invest in a property with an expected rate of return of 3%; you may not come out ahead.

With one exception – publicly traded shares that have the potential to earn income  – if the investment will only earn capital gains on disposition, then the interest paid on money borrowed to purchase the investment is not deductible as a carrying charge, although it may be added to the cost base of the asset to reduce the capital gains tax when the asset is disposed of. 

For interest paid on money purchased to earn income from a business, the interest is a business expense.

Where things get tricky is when the money borrowed cannot be linked directly to the earning of investment income. This can happen when the borrowed funds are used for both personal and investment purposes. A common example is the use of a line of credit for both investing and paying personal expenses. As much as possible, comingling of borrowings for personal and investment purposes should be avoided so that it is clear that the money borrowed was used to earn investment income.

CRA has provided an example of this in its Folio S3-F6-C1 Interest Deductibility:

“Assume an individual has a $100,000 line of credit. The individual uses $60,000 for personal purposes and $40,000 to acquire income-producing property. Accordingly, 40% of the line of credit is used for eligible purposes. Where a repayment of a portion of the borrowed money occurs, it will be necessary to apply this percentage to the remaining balance of the line of credit to calculate how much interest is deductible. If the individual makes a $20,000 payment, the balance on the line of credit will be $80,000. The individual cannot allocate the repayment specifically to the ineligible portion of the borrowing. Instead, applying the original eligible use percentage to the balance, interest on $32,000 of the borrowed money (being 40% of $80,000) will be deductible.”

Also of note is that a recent Federal Court of Appeal decision, in the case of  Van Steenis v. Canada. It upheld a decision by the Tax Court of Canada in a case where a taxpayer borrowed to invest in mutual fund units and subsequently received a return of capital from the mutual fund, some of which he then used for personal purposes. The court’s findings were that the funds originally used for investment purposes were no longer being used 100% for investment purposes and therefore the interest on the funds was no longer 100% deductible. The courts found that the return of capital was actually part of the money invested and, therefore, unless the return of capital was used to pay down the loan or to purchase other investments, the money borrowed was no longer being used to earn investment income. 

The take away for investors who borrow money to purchase mutual fund units is that, if they want to continue to deduct the interest paid on the money borrowed,  they must use any return of capital to either repay the money borrowed or they must re-invest it. This, of course, does not stop the investor from using any income earned on the funds for personal purposes.

Thought Leadership: A Secure Retirement for Seniors?

Running out of money or the inability to maintain a desired standard of living is a very familiar concern for most Canadians. It’s an issue that needs to be addressed, not only by the government, but also by wealth planners who have an opportunity to work with senior clients in overcoming the obstacles they face.

Seniors’ main retirement concerns stem from a few different fronts. Statistics show that the population of Canadians aged 65 and over is increasing. In 1999, the senior demographic made up 12% of the Canadian population.  In 2017 it rose to nearly 17%, and it’s projected to increase to 24% by 2036. This means that programs like CPP, GIS, and OAS will have a larger population to support, and fewer Canadians in the workforce paying into it. Increasing concerns further is the fact that, seniors’ debt load is at an all-time high. In 2016, the percentage of senior families with debt was 42%., 14% of senior families still hold mortgages, and consumer debt was at 37% in 2016. Heading into retirement with a debt load not only creates unease about the future, but also more to think about and prepare for in retirement.

Another issue: as Knowledge Bureau previously reported, as many as 10% of Canadian seniors fail to receive their Guaranteed Income Supplement (GIS), meaning these seniors are missing out on this important income stream in their retirement years. A clear concern for many seniors, as Statistics Canada reports that we could see more than 25% of the labour force made up of people aged 55 or older by the year 2036 – a choice to work later in life which is often motivated by concerns related to financial stability. Service Canada has also noted a few other concerns, including the fact that many Canadians do not know that they have to ask the government to deduct taxes from CCP payments and that when surveyed many Canadians did not know that CPP benefits and contributions were going up starting in 2019.   

And, an additional concern, identified by respondents to our March poll: 68% said that envisioning retirement is as difficult as saving for it.

How does the Finance Department intend to address these concerns? During an April 25 town hall, the Finance Minister indicated that “Every Canadian should feel good about what the future holds, and confident that support will be there when they need it.”  And that seniors, in particular, should feel assured that the Canadian government is investing in their retirement. Mr Morneau went as far to say that with the investments outlined in the 2019 Budget, Canada is doing more to “support seniors and help them enjoy a secure and dignified retirement, free of financial worries.”

A few of the proposed investments include:

  • Helping seniors who choose to work keep more of their earnings.
  • Creating more opportunities for seniors to be active in their communities.
  • Ensuring that eligible Canadians receive their Canada Pension Plan benefits.
  • Introducing new measures to better protect workplace pensions in the event of corporate insolvency; and
  • Create Canada’s first National Dementia Strategy. 

The proposed investments have also opened up further conversation focused on ensuring that everyone entitled to CPP receives it. To deal with this gap, the 2019 Budget has proposed to proactively enroll Canadians over 70 years of age.

But there are critics of the government’s efforts of pension reform in Canada. Baldwin and Shillington co-wrote an article on pension reform in Canada and noted that the Canadian government reform is incomplete. They suggested that the Canadian government has not considered how the current labour market trends affect the Canadian pension environment. They note that slower labour force growth, and the differences in age Canadians enter and exit the labour force need to be factored. An article in The Globe and Mail suggested that the expansion of the CPP is putting pressure on both workers and employers for additional contributions which can affect the Canadian economy. 

So even with the grand vision for no financial worries in retirement, the reality is that for most people, the biggest issue they have when it comes to their future, is “will I have enough?”  Advisors play an important role in ensuring that all Canadians understand and plan for their own investments to prepare for retirement, including their rights to access public programs such as CPP and Old Age Security in the most tax effective way, to make sure they get the most from the A lifetime of work. 

Claiming Office Expenses: Proprietorship vs Employed Tax Guidelines

With the April 30 deadline for individuals now a thing of the past, it’s time to focus on getting those proprietorship returns filed! The deadline to avoid late filing penalties is Monday, June 17 this year, but it’s a good idea to get those returns in sooner.  Here’s why:

Tax Tip for Proprietorships:   Remember, for the self-employed, while the deadline to file is June 17 at midnight; the deadline to pay amounts owing to the CRA was midnight April 30. This means you’ll incur unnecessary interest charges with each day you file late.

Proprietors should be especially careful to file an audit-proof tax return.  They, unlike most employees who obtain T4 slips that are easily checked by the CRA, bear a larger “burden of proof” under our self assessment system of taxation.  All income and deductions must be properly accounted for (understatement of income or overstatement of deductions can result in gross negligence and potentially tax evasion penalties). 

Of particular concern are “mixed use” expenses.  That simply means that any personal portion of expenditures are not deductible.  A good example includes claiming home office expenses, which are particularly tricky because the deductions that qualify for the claim differ for the self-employed, compared to employees or employed commissioned salespeople. 

If you are claiming them, pay particular attention to the following guidelines, which were excerpted from the 2019 edition of Essential Tax Facts, by Evelyn Jacks. This new book, which will help you assemble the correct information for filing your 2019 tax return next tax season will be shipping on May 24 and so be sure to get your pre-order in now.

Home Office:  What can employees claim? What can the self-employed claim? Here are the differences, and what claims are allowable:

  • Employees who do not earn commission can claim: utilities, maintenance and repairs, including light bulbs and cleaning supplies, and rent.
  • Commissioned sales employees can claim: utilities, maintenance and repairs (including light bulbs and cleaning supplies), rent, insurance, and property taxes.
  • Self-employed people can claim: utilities, maintenance and repairs (including light bulbs and cleaning supplies), rent, insurance, property taxes, interest, and Capital Cost Allowance (although this is not a good idea if the home is your principal residence, as you have learned. CCA claims will compromise the principal residence exemption.)

It’s also important to note that eligible claims for home office expenses are limited to income – which is one similarity for both the employed and self-employed. An employee may not claim home office expenses that exceed the income from their employer or income from commissions earned. A self-employed person may not create or increase a business loss with a claim of home office expenses. But the good news is that non-deductible home office expenses may be carried forward (indefinitely) to reduce income in future years.

To qualify to make home workspace expense claims, the space must be:

  • The place where the individual principally (more than 50% of the time) performs the office or employment duties, or
  • Used exclusively in the period to earn income from the office or employment and, on a regular and continuous basis, for meeting customers or other persons in the ordinary course of performing the office or employment duties.

The home workspace must be separated from other living areas in the home, but does not need to be a separate room. Also, the home may either be owned by the taxpayer or rented.

To determine the amount of deductible home office expenses, total expenses for the costs of maintaining the home are pro-rated by a fraction that accounts for the square footage of the home workspace over the square footage of the entire living area of the home.

Employees are subject to further requirements:

  • A completed Form T2200 Declaration of Conditions of Employment, on which the employer certifies that the employee is required to maintain the home office or use the car for employment purposes, and pay the expenses out-of-pocket is required. This form must be signed by the employer.
  • Employees’ claims for home workspace and auto expenses are made on Form T777 Statement of Employment Expenses.  Keep receipts and an auto distance log.