Capital punishment: Most countries encourage investment in their capital markets. So why is Canada going the other way by consi

National Post

2004-02-04


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.