The 2004-2005 Quebec Budget included measures to limit 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 are not impacted by the new rules.
Attached as an Appendix are the details as outlined in the Budget documents. This portion of our commentary will concentrate on how the Quebec rules work with our Investment Leverage programs. Remember, these new rules only apply to Quebec income tax and do not affect the Federal income tax rules.
Under the prior system an individual who incurred expenses in excess of investment income could deduct the excess against other sources of income. Under the current rules, investment expenses, which include interest expenses, will be limited to the amount of investment income actually reported.
What this means for the investment leverage programs offered by Manulife Bank.
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/or taxable fund switches. Less tax efficient funds 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 funds 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.
Below is an illustration of how the Quebec rules operate in conjunction with the current Federal tax deduction rules using a 100 per cent 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 NIL 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: $50,000 loan, 0 per cent distributions for 10 years, 9 per cent rate of return, 7 per cent loan rate, 48.22 per cent marginal tax rate
The illustration above represents a worse 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 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, that would mean that all amounts reported would qualify not just the leveraged portion.
Quebec Budget 2004-2005
The investment expenses considered 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 advisers;
- interest paid on borrowings contracted to acquire bonds, stock, or units of mutual fund trust;
- the portion of the loss of a partnership of which the individual is a specified member.
However, losses suffered on the rental of an asset will not be considered as investment expenses for the purposes of this measure.
The investment income considered in calculating the limit on the dedutibility of investment expenses will be all income from property and will include in particular the following investment income that would otherwise be included in the calculation of the cumulative net investment loss:
- taxable dividends of taxable Canadian corporations;
- interest from Canadian sources;
- the share of the income of a partnership of which the individual is a specified member;
- gross foreign investment income;
- taxable capital gains not eligible for the exemption on taxable capital gains;
- 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 will not be considered as investment income for the purposes of this measure.
Calculation of deductible investment expenses for a taxation year
As mentioned above, investment expenses incurred to earn investment income during a given taxation year will be deductible up to the amount of investment income earned for such given taxation year. Investment expenses that cannot be deducted in a given taxation year may be carried over against investment income earned in one of the three preceding taxation years or in 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 that applied regarding a capital loss.
Other terms and conditions
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 his income for a given taxation year, for an amount regarding investment expenses incurred in a prior or a subsequent taxation year and that could not be deducted because of the application of this measure.
If the non-deducted investment expenses were incurred in a taxation year subsequent to the given taxation year, the individual must then provide the MRQ, on a prescribed form, with a request to amend the tax return he filed for such given year.
Such request must be filed no later than the deadline for filing the individual’s return for such subsequent year and the individual must, when he files the prescribed form, indicate the fraction of non-deducted investment expenses that must be applied to each of the taxation years preceding the year when the investment expenses were incurred but could not be deducted.
Lastly, an individual may claim in calculating his income, for the taxation year during which he died and for the preceding taxation year, the investment expenses not deducted because of the application of this measure and for which he did not claim a deduction in the calculation of his income for another taxation year.
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 ($816 in this example) can be used to offset other investment income and can be carried back three taxation years or forward indefinitely.