Ottawa proposes tighter deductibility rules for investors, business owners

(November 3, 2003) The federal finance department has introduced some controversial changes to income tax laws that, if approved, could have dramatic implications for investors and small business owners.

Ottawa wants to update the rules on deductibility of losses based on the concept of reasonable expectation of profit, says Jamie Golombek, a tax specialist with AIM Trimark Investments.

“What they’re really doing is putting in new legislation that is going to essentially overturn, or at least supersede, the court cases that they’ve lost dealing with reasonable expectation of profit and interest deductibility,” Golombek says.

In one of the court cases, an investor attempted to deduct losses on rental properties purchased through a developer. CCRA wanted to deny the losses on the basis there was no reasonable expectation of profit on the properties, but the Supreme Court of Canada sided with the investor.

Under the proposed provisions released last Friday, losses can only be deducted in situations where it is reasonable to expect that the investment will realize a cumulative profit.

“For example, if an investor financed an investment with little potential to earn income, such as a growth share, the interest deduction would be limited to the amount of dividends received,” says Dave Clarke, manager of taxation services at Collins Barrow in Ottawa.

“Because the financing charge is going to be greater than any dividend you receive on the growth stock, you’re not going to be able to deduct that financing charge,” he says. “It’s impacting every investor who is using financing.”

Clarke says that since most equity investments are focused on earning capital gains as opposed to dividends the proposed legislation will have a “profound impact on investing decisions due to the inability of taxpayers to deduct the interest charges from their income.”

Small business owners will still be able to deduct losses in the start-up phase, Clarke says, but could run into trouble if they decide to close down a failing business. “As the new reasonable expectation of cumulative profit (REOCP) test will not be met in the year the small business owner decides to close, there is a potential that no losses for that year will be deductible.”

Investors who fully finance the purchase of rental property will also be affected by the provisions, Clarke says. “In current legislation, the interest deduction helps finance the property, so you’re using the interest to reduce taxes and you’re incurring a loss in the property and you expect to sell at a capital gain. Now Ottawa will look at this and say if you over-leverage this, you’re not going to make a profit and they’re going to deny the losses.”

Many tax shelters will become a thing of this past under the legislation, Clarke predicts. “Most tax shelters provide a mechanism for investors to access deductions resulting in tax savings in excess of their original investment. As the intention is never to realize a cumulative profit from the investment, the REOCP test will not be met and the losses realized from the tax shelter will be denied.”

The proposed changes will be effective for the 2005 tax year. Clarke says because there’s no grandfathering clause, the proposals could affect long-term tax shelters and other types of investments financed past 2004. The finance department is accepting comments on the provisions to the end of 2003.

Filed by Doug Watt, Advisor.ca, dwatt@advisor.ca