We have blogged about income splitting arrangements available to individuals who wish to loan funds to his/her lower income spouse or adult child, or in the case of minor children, a discretionary family trust. Such loans would be used to invest in income producing properties such marketable securities, mutual funds, real estate income trusts (to name a few). The income from these properties less the interest paid on the loans would be claimed by the spouse, beneficiaries of the trust etc.
For these plans to work as designed, we have blogged about how the loan must carry the appropriate rate of interest (i.e. at least the prescribed rate of interest pursuant to the Income Tax Act) and the interest on the loan must be paid by a certain date every year.
What has not been written about very much about is how one has to be careful about the use of the funds borrowed to maintain full interest deductibility. Generally, the Income Tax Act allows a taxpayer to deduct interest expense on borrowed money that is used to earn income from a business or property.
The use of the borrowed money is determined for the taxation year or period in which the interest deduction is being claimed, commonly referred to as “current” use. Current use must be for the purpose of earning income for it to be “eligible” for interest deduction. To maximize interest deductibility so the income splitting plan works as efficiently as possible, the current use of the borrowed money should remain eligible throughout the period.
When property acquired with borrowed money is disposed of and the proceeds are used to acquire another property, the current use of the proceeds is relevant. Former use is not. This is a principle that has been developed by the courts and the Canada Revenue Agency.
In a recent case tax court case Van Steenis v. The Queen (2018 DTC 1063 (TCC)) this principle was extended to “return of capital” in mutual fund trust units. The taxpayer received a significant portion of the investment money as return of capital. The taxpayer continued to own the units, but some of the return of capital went for personal and “ineligible” use. The CRA denied part of the interest deduction to the extent the use of the returned capital was ineligible. The Tax Court agreed.
In addition to exercising care over making the interest payments when they should be made, be also mindful of how the borrowed money is used on a continued basis to preserve maximum interest deductibility.