CAPITAL PUNISHMENT
by Jamie Golombek

Last October, the federal government introduced new tax rules severely limiting the deductibility of losses -- in particular, rules that restrict losses created through the deductibility of interest. The new rules, if enacted as proposed, would be effective beginning in 2005 and represent a new and unnecessary limitation on the deductibility of interest and other expenses. The measures will limit the deductibility of interest on money borrowed to purchase securities (including common share and mutual funds) and thus harm Canada's capital markets, Canada's global economic competitiveness and the Canadian economy.

Under existing tax rules, interest is tax deductible if it is paid for the purpose of earning income. For example, if an investor borrows to purchase common shares that have the ability to pay dividends, he or she can deduct the interest expense since the interest was paid for the purpose of earning income. Alternatively, if someone borrows money to finance the purchase of a new plasma television, the interest would not be deductible since there is no source of income from that particular "investment."

Courts supported the view that as long as an investment has the potential to earn income, interest on borrowings used to purchase the investment should be tax deductible. The draft legislation introduces a new test: A taxpayer will only be allowed to deduct interest if it is "reasonable" to expect a "cumulative profit" from the investment during the time the taxpayer can "reasonably" be expected to hold the investment, excluding any potential capital gain on ultimate disposition.

When the legislation was first announced back in October, the accompanying press release claimed that the new rules "will reaffirm many current practices that support the deductibility of interest, including those relating to the deductibility of interest on money borrowed to purchase common shares." This assertion is simply not supportable. The reality is that many investments are highly speculative, especially in the case of start-up companies and companies engaged in high risk businesses, and the probability of a cumulative profit is quite low. These new rules will harm the ability of Canadian companies to raise capital for other than "sure things," which are few and far between. The government should be supporting entrepreneurial endeavours -- not discouraging them.

A quick review of some basic stock market data regarding both dividend yields on stocks and the typical holding period lead to two observations. Firstly, with the current average dividend yield approximating 1.7%, there are virtually no common shares of Canadian corporations which pay a regular dividend anywhere close to the typical lowest borrowing cost available to an investor (currently around 4.25%). Secondly, the normal hold period of investors is actually quite short, averaging less than five years. Thus, it is generally not reasonable to expect that the average taxpayer will realize a "cumulative profit" from purchasing and holding stock "for the period in which the taxpayer ... can reasonably be expected to hold" the stock. For example, assuming a stock price growth rate of 7%, a taxpayer who borrows at a 4.25% interest rate to purchase common shares that pay a dividend of 1.7% would have to hold the stock for 25 years before he or she realizes a "cumulative profit" from the investment. Put another way, the price of the stock would have to increase about 5.5 times before the investor realized a "cumulative profit" under the same assumptions. Clearly, most taxpayers are likely to dispose of stock long before it has increased by such a large multiple.

This example clearly illustrates that most investors who purchase stock using borrowed money do not have an objective expectation of a "cumulative profit." When the Supreme Court of Canada dealt with this issue, it concluded that the measure of income for purposes of the profit test should be gross revenue. This conclusion maintained the integrity of the capital markets and was therefore clearly correct from a broad policy point of view.

In contrast, the draft legislation will not maintain the integrity of the capital markets. In the future, Canadians who borrow to make investments will be penalized, making it more difficult and more expensive for Canadian companies to raise capital. One would be hard-pressed to find another country in the world with mature capital markets that discourages investment in this way. The result is also inequitable since individuals with accumulated capital, who don't need to borrow, can continue to generate returns from the investment of their capital.

If the government feels compelled to advance a new test for the deductibility of expenses such as interest, the test should be an expectation of a net profit on a before tax or cash basis. In measuring net profit for purposes of this test, capital gains should be taken into account. This type of test would accord with normal economic behaviour in the marketplace. Taxpayers obviously take into account the potential for gains in making investment decisions, even if the realization of such gains is not the investment's primary purpose.

In effect, the test should be based on how taxpayers would behave if tax considerations were not an issue -- on the reality of how investors behave, not on some assumptions that investors can rarely satisfy.

Finally, one has to hope that our current government would take a lesson from one of its predecessors. Under Trudeau's leadership in 1981, the government introduced similar rules restricting interest deductibility -- rules that were later abandoned after much public outcry.

This article was prepared by Terry Fay who is an Investment Advisor with Dundee Securities Corporation, a DundeeWealth Inc. Company. This is not an official publication of Dundee Securities and the author is not a Dundee Securities analyst*. The views (including any recommendations) expressed in this article are those of the author alone, and they have not been approved by, and are not necessary those of Dundee Securities.

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