July 16, 2008, 6:00 am

Playing on Words with the CRA

by: The Financial Blogger    Category: Financial Planning,Leveraging Strategies
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Sometimes, I really love my Country! While we are getting taxed from right, left and center, the Canadian Government is still giving us some room for tax saving in the interpretation of its law. The CCRA, Canadian Revenue Agency, is writing all the rules for tax credit and deductibility. One of most important line in your tax report is probably the line 221: Carrying charges and interest expenses.

In fact, it is a line that is quite important for someone who is interested in leveraging. For example, the legibility of the Smith Manoeuvre depends on this tax rule.

I will refer you to the full description of the line 221 here. However, here are the key points you need to remember:

You are allowed to claim the following charges and interest you paid to earn income from investments:

– Management fees (not MER’s since they are included in your net return but fees related to Private Wealth Management would be a good example).

– Safe-keeping related charges (such as safety deposit box to hold your 1806 Bank of Holland Share Certificates 😉 ).

– Fees for certain investment advice (fees paid to a person who’s principal activity is to give advice about buying or selling stocks).

– Most interest you pay on money you borrow for investments purposes, as long as you use it to earn investment income such as dividend and interest income. The last part of this rule is the most important: if the only earnings your investment can produce are capital gains, you CANNOT claim the interest you paid.

When you first read it, you may think: what is the purpose of borrowing to invest if it’s only to get me GIC returns? Well, this is where the interpretation goes: since they don’t mention that most or the majority of your investment income has to come from dividend or interest sources, you still can invest a part of the money to make capital gains without getting questioned by the CRA. It’s only a matter of playing by the rules (and by their weakness).

I think that the Government didn’t want investors to speculate with borrowed money. However, if you are able to increase your level of income with a good leverage strategy, this is simply good financial planning.

On the other side, having interest and dividend income means that you have less volatile assets in your portfolio which might not be a bad thing when markets are dropping.

The best advice as to know if you can deduct or not your interest and other charges paid to get investment income is definitely to hire an accountant to fill up your tax report correctly and according to the proper rules from the CRA. The last thing you want is to get caught for $5,000 of unpaid taxes because you misinterpret a rule!

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I think that most stock market investments qualify because you would expect them to pay some kind of dividend someday. As you know from your MBA finance classes, the value of the stock is supposed to be the present value of all the future dividends. You could easily argue that every stock, unless they specifically say something like “We’re not paying dividends”, will eventually generate excess cash and pay dividends to the shareholders. Maybe the capital gains are larger than the dividends by the time you sell, but it’s still an income investment.

It’s the same with a business. You can deduct business expenses as long as there is an expectation of profit. It doesn’t mean that profit actually has to come.

I (I’M NOT AN ACCOUNTANT) would deduct all my investment related interest. If there was a portion later that was found to be categorized incorrectly then I’ll take that risk rather than give the government $5K that I might not have to.