Returns of Capital by Unit Trust Limit Investor's Deductible Interest

In Van Steenis v. The Queen (2018 TCC 78; informal procedure), the TCC held that a taxpayer's entitlement to deduct interest on borrowed money used to acquire mutual fund trust units was limited to the extent that amounts received by the taxpayer as returns of capital on the units were not reinvested in another income-earning use. Although the TCC's decision is consistent with the CRA's current administrative position (CRA document nos. 2003-0000825, May 13, 2003 and 2002-0142475, July 16, 2002), it relies on the questionable proposition that all returns of capital on trust units represent returns of the investor's original investment in the trust.

In 2007, the taxpayer in Van Steenis borrowed $300,000 to purchase mutual fund trust units. From 2007 to 2015, he received returns of capital on the units totalling $196,850. Although the taxpayer used most of the distributed cash for personal purposes, he sought to deduct all of the interest payable on the borrowing each year. The taxpayer was reassessed in 2017 to deny a portion of the interest deductions claimed in his 2013-2015 tax returns, consistent with the CRA's administrative policy.

In ruling against the taxpayer, the TCC stated that under the scheme of the Act, returns of capital on mutual fund trust units are returns of the unitholder's original investment, finding support for this view in subparagraph 53(2)(h)(i.1), which reduces the unitholder's ACB in such units by the amount of any returns of capital thereon. The TCC therefore found a direct link between the borrowed money and the taxpayer's current use of the distributed cash, and concluded that the borrowed money ceased to have an eligible use to the extent that the distributed cash was used solely for personal purposes.

The TCC's reasoning in this case is dubious. When an investor acquires trust units with borrowed money and later receives a return of capital thereon, there is no disposition of trust units and no acquisition of replacement property to which the borrowed money can be directly linked. The investor's entitlement to deduct interest should therefore continue to depend on whether the units are held for an income-earning purpose. If Parliament had intended that such distributions be treated as returns of the taxpayer's original investment, the definition of "disposition" in subsection 248(1) would not include the carve-out in paragraph (h), which specifically excludes unit trusts from the general rule deeming a disposition of a beneficiary's capital interest in a trust (or of a part thereof) to occur upon a capital distribution by a trust to the beneficiary. Subparagraph 53(2)(h)(i.1) is more properly viewed as a rule designed to prevent a taxpayer from realizing a capital loss on a subsequent disposition of a capital interest in a trust, to the extent that (subject to certain qualifications) the taxpayer has previously received tax-free distributions out of the income or capital of the trust. The fact that a distribution out of the trust's income for tax purposes may be subject to subparagraph 53(2)(h)(i.1) (for example, if a subsection 104(13.1) designation has been made) is inconsistent with the TCC's view that all returns of capital are returns of the taxpayer's original investment.

Further, even if the borrowed money could be directly linked to the distributed cash, in the absence of a disposition of trust units, it is simply not true to say that every return of capital necessarily represents a return of the taxpayer's original investment. The investment objectives of mutual fund trusts commonly include both income and capital appreciation, with monthly distributions fixed by the underlying portfolio's expected total return. Where the per-unit net asset value (NAV) of the trust has appreciated over the relevant holding period, given the fungibility of cash, there is no principled reason that a return of capital should be viewed as a return of the investor's original investment rather than a distribution of the investor's share of the underlying portfolio's capital appreciation. Moreover, leaving aside concerns about potential abuse (which are more appropriately addressed by GAAR), it is unclear why an investor should not be entitled to avail itself of the "flexible approach" described by the CRA in paragraph 1.38 of Income Tax Folio S3-F6-C1 ("Interest Deductibility") when one is determining whether a return of capital should be linked to the investor's original investment.

Conversely, if the per-unit NAV has depreciated during the relevant holding period, then (except when the return of capital might reasonably be viewed as a distribution of capitalized or sheltered income) it is reasonable to conclude that the return of capital represents a return of the investor's original investment. Interestingly, while the point was not explicit in the pleadings in Van Steenis, it appears that although the relevant fund was focused on dividend-paying Canadian equities, the majority of its distributions were returns of capital, which resulted in a depreciation of its per-unit NAV during the relevant holding period. Accordingly, although one may take issue with the TCC's reasoning, its conclusion on the particular facts of the case appears to be well founded.

Kabir Jamal
Goodmans LLP, Toronto

Canadian Tax Focus
Volume 8, Number 3, August 2018
©2018, Canadian Tax Foundation