Tax – Doug Carroll

Whether interest on T-series distributions is deductible

At issue

Borrowing money for investment is a way to leverage up the amount of capital on which you can generate income. Of course that can also work against you by magnifying losses, but whichever way the performance goes, the interest on that borrowed money is usually tax-deductible.

For a straight buy’n’hold investor, deductibility is in turn straightforward. But when the borrowed money is repositioned in some way – whether by the investor’s actions or by the operation of the investment itself – deductibility can be brought into question.

Mutual funds – return of capital

In Van Steenis v. The Queen, the taxpayer borrowed $300,000 in 2007 to invest in units of a mutual fund. The fund had the capacity to return capital to investors, a feature often called ‘tax-efficient’ or t-series funds. In this case, the fund returned capital each year up to 2015, to a total of $196,850. Mr. Van Steenis used some of that money to pay down his loan, but the majority was used for personal expenses.

The Canada Revenue Agency reassessed Mr. Van Steenis for his interest expense deductions from 2013 to 2015, denying the portion related to his personal expenses.

Requirements for interest deductibility

As background, there are four requirements for interest deductibility:

interest must be paid or payable in the year.
it must be pursuant to a legal obligation on the borrower to make the payment,
the money must have been borrowed for purpose of earning income from a business or property, and
the amount of interest must be reasonable.

Importantly on the third point, it is the current use of borrowed money that is relevant in determining the income-earning purpose. On appeal, Mr. Van Steenis’ position was that he borrowed the money in 2007 to purchase mutual fund units, and that he continued to own those same fund units in the years in question, so therefore he should be entitled to continuing interest deductions.

Furthermore, he had no control over how the fund company characterized the distributions. He argued that though the fund was returning capital from its perspective, that does not necessarily correlate with each unitholder’s actual invested capital, and therefore he should not be bound by that characterization.

Ruling on continuing purpose

The judge did not accept Mr. Van Steenis’ arguments. Almost two-thirds of his capital was returned to him over the years, and more than half of that was used for personal purposes. Returning to that third deductibility requirement, there was no longer a direct link between the borrowed money and investment in the fund units.

In support of this finding, the judge points to the fact that a mutual fund trust is by its nature a flow-through structure. Income that it distributes to unitholders is included in their income and deducted from the fund’s income. By contrast, capital distributions result in a dollar-for-dollar reduction in the unitholder’s adjusted cost base, according to specific provisions of the Income Tax Act.

In sum, a return of capital reduces the amount of the investor’s own money that is in fact invested. If the entire returned capital had been used to reduce the borrowed principal, all ongoing interest charges would have been deductible because all remaining outstanding indebtedness would still be directly connected to the fund units.

As it was, more than half of that money was spent on personal expenses, and you don’t get a deduction for personal spending.

Minister of Revenue confirms the CRA is not going after retail employee discounts

At issue

In the house where I grew up, we bought almost all of our clothing, housewares and other durable goods from one retailer. That’s because it was the company where my dad worked, and part of the employment deal was a discount on purchases.

That’s a common practice for retail employees and restaurant workers, and one that garnered some front page media attention recently. It’s not because of any public uproar as if it was some kind of scandalous abuse. On the contrary, it was prompted by what appeared to be a reversal of the Canada Revenue Agency’s longstanding practice of acknowledging these as non-taxable items.

Is the CRA really intending to begin requiring employers to track the savings each employee receives, and report that as a taxable benefit each year?

Income Tax Act (ITA) Canada

Per paragraph. 6 (1)(a), income from employment includes “benefits of any kind whatever received or enjoyed by the taxpayer …in the course of, or by virtue of the taxpayer’s office or employment”. Some exceptions are allowed in the following subparagraphs, with no mention of discounts.

Income Tax Folio S2-F3-C2, Benefits and Allowances Received from Employment

The CRA has an ongoing multi-year project migrating and consolidating its tax practice guidance from a variety of older formats into the online Folio format. This particular Folio was published in October 2016, but the story hit the headlines in October, 2017.

The Folio states that a discount is generally to be included as an employee benefit under para. 6(1)(a). With the exception of discounts made available to the general public, “the value of the benefit is equal to the fair market value of the merchandise purchased, less the amount paid by the employee.” Responsibility is placed on the employer to “determine the value of the benefit to include in an employee’s income.”

CRA letters 2017-0726641M4 & 2017-0729161M4 – Taxability of employee discounts

An immediate firestorm erupted for the Minister of Revenue Diane Lebouthillier, and within a day she clarified that this was the action of CRA bureaucrats, not the government’s policy intention. One day later, Folio S2-F3-C2 had been taken down from the CRA website, replaced by as a statement that it was “currently under review.”

We now have written affirmation that employee discounts are not on the CRA’s radar. Two letters were published in the last couple of months, from the Minister of Revenue herself. The letters are almost verbatim one another, with one providing a bit of additional reassurance to restaurant employees. The Minister states that the “longstanding administrative policy that employee discounts on merchandise are generally not taxed … is still in place and is explained in Guide T4130.”

T4130 Employers’ Guide – Taxable Benefits and Allowances

This Guide advises an employer that if it sells “merchandise to your employee at a discount, the benefit he or she gets from this is not usually considered a taxable benefit.” If the discount is below the employer’s cost, there would be a taxable benefit for the difference between fair market value and the price paid.

Practice points

Generally, benefits received by an employee from an employer are taxable.
Discounts for an employer’s merchandise and meal discounts for restaurant employees continue to be non-taxable, per the CRA’s longstanding policy.
If a discount is below employer cost then a taxable benefit may still arise.

Advertising on social media – Deduction complication … and simplification

At issue

We are about two decades into the commercial internet age. Alongside the expanding list of never-before-seen online goods and services, traditional bricks-and-mortar businesses are simultaneously being transformed by this digital revolution. The lines have blurred in terms of physical production, as have geographic and regulatory borders.

When it comes to taxes, some may find it appealing (possibly amusing) to see our authorities playing catch-up, but that means uncertainty for entrepreneurs. To make viable financial plans, businesses need to know whether and how existing rules will map over into their digital activities, or if they have entirely new compliance requirements to contend with.

Early on much of the focus was simply on what is subject to tax, and as new offerings emerge those determinations continue. Equally important is the question of what may be deducted from that income, to which the Canada Revenue Agency has recently provided some clarity in the area of advertising on social media.

Income Tax Act (ITA) Canada – Deductions generally

The general ability to take a tax deduction is expressed first as a denial, followed an exception:

18 (1) In computing the income of a taxpayer from a business or property no deduction shall be made in respect of (a) an outlay or expense except to the extent that it was made or incurred by the taxpayer for the purpose of gaining or producing income from the business or property [my emphasis obviously]

Of course, numerous provisions constrain the application of that general exception. Some of those are overarching such as the reasonableness requirement in s. 67. Others are more targeted, in particular for our purposes the sections dealing with advertising.

ITA – Limitation on advertising expense

The advertising limitations are expressed in s.19 for newspapers (including any “comics supplement”), s.19.01 for periodicals, and s.19.1 for a broadcasting undertaking.

Much of these rules address cross-border issues: from the citizenship of the publisher; to the degree to which editorial activity occurs in Canada; to the geographic location of typesetting or physical printing; to the proportion of editorial-to-advertising space, and more. Depending on the resolution of these issues, advertising may be fully deductible, half-deductible, or not at all – and in some cases a reference to the Department of Canadian Heritage may be called for.

It requires a great deal of interpretation to apply that language and those concepts in a dynamic new media industry, not to mention the due diligence burden placed upon the taxpayer to ascertain the necessary information to work with. In fact, it would not be unreasonable to characterize that traditional framework as antiquated, and in many ways unmanageable.

CRA letters 2017-0708891M4 (August 2017) and 2017-0719471E5 (September 2017)

In August 2017, the Minister of National Revenue Diane Lebouthillier personally responded to a taxpayer inquiry sent to a Member of Parliament. The question was whether foreign online advertising was deductible. The Minister acknowledged the general s.18 deductibility and the constraints of ss. 19, 19.01, and 19.1. She then advised, as head of the CRA, that those limiting rules would not be applied to the deductibility of advertising expenses on foreign Internet websites.

Another letter was issued by the CRA in September 2017, responding to a similar issue. The question was about the treatment of advertising on social media. The agency confirmed that the Canadian content and ownership rules would not apply to social media sites or networks, including foreign websites.

Practice points

Expenses are generally deductible if an outlay is incurred to generate income from a business or from property, and it is reasonable in the circumstances.
There are rules that limit deductibility of advertising expenses, contingent on whether certain Canadian content or Canadian ownership requirements have been met.
The CRA has confirmed that Canadian content / foreign rules will not apply to advertising on social media networks or foreign websites.