Interest deduction denied for return of capital of mutual funds
As discussed earlier in this letter, if you borrow money to purchase mutual funds, the interest expense on the borrowing will normally be deductible in computing your income. However, mutual funds will sometimes pay out a return of your originally invested capital (along with income earned by the funds). If this occurs, the interest deduction may be affected, depending on how you use the returned capital.
In the recent Van Steenis case, the taxpayer took out a $300,000 loan to buy units of a mutual fund. Over the course of several years, approximately 2/3 of this amount was paid out to him as a return of capital. He used most of this amount for personal purposes. The CRA assessed the taxpayer to disallow the interest expense on the portion of the loan reflecting this returned capital that was used for personal purposes.
The taxpayer argued that he should be allowed to continue to fully deduct the interest, since he continued to own the units in the mutual fund. He also argued that he had no choice in the matter, since he had no control over the characterization of the money distributed to him from the mutual funds (i.e. as either income or return of capital).
On appeal to the Tax Court of Canada, the Tax Court Judge sided with the CRA and upheld the assessment. The Judge held that the returned capital was no longer being used for income-earning purposes – it was no longer invested and was instead used for personal purposes. As a result, interest on the portion of the loan reflecting the return of capital was not deductible.