Since 2004, for provincial tax purposes, Quebec has limited the deductibility of investment expenses incurred by an individual or trust to the amount of investment income earned during the year. The limitation on the deductibility of investment expenses applies to those expenses incurred to earn income from property, other than rental income. Investment expenses incurred to earn active income, such as income from a business or income from the rental of an asset, aren’t impacted.
Types of investment expenses
The investment expenses included in calculating the limit on the deductibility of investment expenses will be all the expenditures incurred to earn income from property, other than rental income, and will include, in particular, the following investment expenses that would otherwise be considered in calculating the cumulative net investment loss were it not for this limitation:
- investment administration or management expenses
- stock or securities custody expenses
- fees paid to investment advisors
- interest paid on borrowing contracted to acquire bonds, stock, or units of a mutual fund trust
- the portion of the loss of a partnership in which the individual is a specified member.
However, losses suffered on the rental of an asset won’t be considered as investment expenses for this deduction.
Types of investment income
The investment income for calculating the limit on the deductibility of investment expenses will be all income from property and will include, in particular, the following investment income that would otherwise be included in calculating the cumulative net investment loss:
- taxable dividends of taxable Canadian corporations
- interest from Canadian sources
- share of the income of a partnership in which the individual is a specified member
- gross foreign investment income
- taxable capital gains not eligible for the capital gains exemption
- benefits received as a shareholder of a corporation
- royalties from Canadian sources
- accumulated income of a life insurance policy
- income from a trust
- income from property attributed to shareholders.
However, income from the rental of property won’t be considered as investment income for these purposes.
Calculation of deductible investment expenses for a taxation year
For provincial tax purposes, investment expenses incurred to earn investment income during a given taxation year will be deductible up to the amount of investment income earned for that taxation year. Investment expenses that can’t be deducted in a given taxation year may be carried back and used to offset investment income earned in one of the three preceding taxation years or carried forward to any subsequent taxation year, provided the investment income earned in any of these years exceeds the expenses then deducted. The tax treatment of investment expenses will thus be similar to those applied to a capital loss.
The carry-over of investment expenses not deducted for a taxation year will be made in the calculation of income. Accordingly, an individual may claim a deduction, in calculating income for a given taxation year, for the amount of investment expenses incurred in a prior or a subsequent taxation year and that couldn’t be deducted in that year.
Investment expenses in excess of investment income dating back to 2004 are tracked by the individual and provided to Revenu Quebec on Schedule N. They’re then carried forward and can be used in future years when investment income is earned.
If individuals want to reduce net investment income from a previous year, they must complete form TP-1012.B-V, Carry-Back of a Deduction or Tax Credit. This form is filed separately from an individual’s tax return.
Lastly, in calculating income for deceased individuals in the year of death and the preceding taxation year, a liquidator may claim the investment expenses not deducted and for which a deduction wasn’t claimed in the calculation of income for another taxation year.
Remember, these rules only apply to Quebec income tax returns for individuals and trusts, not corporations, and are separate from the federal income tax rules. For more information on the federal rules for investment fee deductibility see, “Deductibility of investment management fees.” Read “Tax deductibility of interest on an investment loan” for the federal interest deductibility rules related to loans used to purchase investments.
Under the federal rules an individual who incurs expenses in excess of investment income can deduct the excess against other sources of income. However, for Quebec tax purposes, investment expenses, which include interest expenses, will be limited to the amount of investment income actually reported.
What this means for leveraged investments
Under the Quebec rules, ongoing interest deductibility will be determined by the amount of distributions reported on tax slips and taxable capital gains realized due to redemptions and taxable fund switches. Less tax-efficient investments will permit a deduction of some, if not all, of the investment expenses on an ongoing basis, with the balance used to offset taxable capital gains at the end of the program. More tax-efficient investments will permit less deduction on an ongoing basis with the majority of the expenses being carried forward to offset the taxable capital gains realized at the end of the program. The investment income used to determine the amount of expenses that can be deducted in a given year isn’t limited to the leveraged investment and includes investment income earned on other taxable investments, leveraged or not.
The example below illustrates how the Quebec rules operate in conjunction with the federal tax deduction rules using a 100% leveraged investment where no distributions were reported for a full 10 years. If this were the case and this was the only property held by the client that produced investment income to offset the interest expense, then the interest deductions during the life of the program would be zero for Quebec tax purposes. However, the interest expense would be used at the time the program was wound up to reduce the taxable capital gains realized on the sale of the investment.
Assumptions: $100,000 loan, 0% distributions for 10 years, 6% rate of return, 5% loan rate, 53.31% marginal tax rate.
When investment values increase over time, leveraged results benefit from having a larger lump sum ($100,000) invested immediately. The annual interest payments provide federal tax savings on an annual basis, but since there’s no annual investment income, the Quebec tax savings are deferred. At the end of the time horizon, there’s no Quebec tax on the taxable capital gain because the deferred interest expense of $50,000 ($5,000 of annual interest x 10 years) exceeds the taxable capital gain of $39,542 (50% of $79,085).
The excess expenses of $10,458 ($50,000 minus $39,542) can be carried back three years or forward indefinitely for Quebec tax purposes, providing a deferred provincial tax savings of $2,693 ($10,458 x 25.75% provincial tax rate). Therefore, only federal tax applies on the capital gain.
The taxable capital gain of $5,761 (50% of $11,522 total capital gain) in the non-leveraged results will be subject to both federal and Quebec taxes since there are no interest expenses that can be deducted.
The illustration above represents a worst-case scenario where no income is reported and, therefore, no deductions are allowed until the end of the program. Leverage is still a viable option since compounded returns on a lump-sum investment will generally outperform an investment of smaller amounts made each year. The fact that the interest expense can be carried forward to future years and is deductible against taxable capital gains still provides a provincial tax benefit over non-leveraged investing.
The Quebec rules allow the interest expense to be deducted against all investment income taxable in the year. In situations where a portion of the investment is client equity or where the client has other investments, all amounts reported would qualify, not just the leveraged portion.
1 This assumes a full interest deduction for federal tax purposes and no interest deduction for Quebec tax purposes. 2 Quebec taxable capital gains are reduced by any cumulative undeducted expenses. Excess cumulative undeducted expenses ($10,458 in this example) can be used to offset other investment income and can be carried back three taxation years or forward indefinitely. 3 The adjusted cost base is equal to the total annual contributions made over the time horizon. The example assumes no distributions from the investment, so there are no amounts re-invested during the period.
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