Financial Webring Forum

I received this e-mail message a couple of weeks ago and I'm hoping for input as to whether or not it's legal. Even though two North Vancouver C.A.'s have endorsed this strategy. I personally think it likely wouldn't stand up in court.

But perhaps I'm being overly cautious.

For those of you who don't want to read to whole text, the jist of the idea is that unincorporated businesses should add up their monthly expenses and then using a LOC or some other borrowing option to borrow this money to paid the bills. You then would write yourself a cheque from the business to yourself as a reimbursement and put this down against your mortgage. This according to Fraser Smith and the two C.A.'s would result in the LOC interest being deductible, and thus you have effectively converted non deductible interest into deductible interest.



A Smith Manoeuvre accelerator for unincorporated
Canadian entrepreneurs.


Proprietors and Partners
There is a rather large group of Canadians running small businesses on an unincorporated basis, who also have a mortgage on their home. Ordinary Canadians, as well as these small business families are all able to enjoy free tax deductions and rapidly growing investment portfolios simply by implementing The Smith Manoeuvre. To also own an unincorporated business of any kind brings significant increased financial opportunity to this group of entrepreneurs.
When most small businesses get started, part of the excitement is going to the bank to open a business account. You order company chequebooks and deposit books. The money starts to flow in to your new bank account and at the end of the month you pay the company bills. If there is anything left, you write a cheque to yourself, call it draw, and deposit it to your personal chequing account.
If you don’t have a house mortgage this is a fine and efficient setup. But if you do have a mortgage (or other non-deductible debt), then there is a much better way to structure your banking. It is called the Cash Flow Dam and it is so little known that Google can’t find it.

Rationale

We will rely on the tax fact that money borrowed personally to invest in a business in order to generate income gives rise to deductible interest on that loan. The interest expense on the house mortgage is not deductible.
Further, nothing in the tax act says that you have to pay company expenses with revenue generated by the unincorporated business.
Being unincorporated means that for tax purposes, you and your company are the same person. Your accountant will total your annual company revenues, subtract company expenses and the difference, the profit, will be added to your other personal income for the calendar year.
The Smith Manoeuvre increases in power if the first mortgage can be paid down faster. That will obviously happen if we can divert a portion of the revenue stream from your business against the first mortgage. The Cash Flow Dam makes that happen.
The amount of cash available from the company to apply against the first mortgage monthly will be an amount equal to the expenses of the company for the month. (Note that your monthly draw is not classified as an expense of the company.) Capital expenses as well as operating expenses qualify for the tax-deductible interest treatment if this expense is paid with borrowed money.

Mechanics

1. At the end of each payables interval, tally all qualifying expense in the company. Keep good records each month. Be precise.

2. Write a cheque against your Smith Manoeuvre investment line of credit for the same amount, notate it “Company Expenses” and make it payable to your company. Pay the expenses with this money.

3. Write a company cheque payable to yourself for the total amount of the expenses. Notate it as “Draw – re: expenses”.

4. Deposit the cheque into your personal chequing account. From there, pay down your first mortgage by the same amount. This will be a lump sum payment in addition to your regular monthly payment. If your bank won’t accept lump sum overpayments put the money in a separate savings account until you are eligible to make an overpayment. (Another reason to avoid locked in mortgages.)

Payoff

Using The Smithman Calculator example in Figure 3.2 of the book The Smith Manoeuvre, we determined that a Canadian family, The Blacks, doing The Plain Jane version of The Smith Manoeuvre would reduce their tax bill by $41,980, knock 2.75 years of their 25-year mortgage and have an investment portfolio of $309,882, net of the investment loan. This assumes investments grow at an average of 10% per year, which is the average annual growth of the TSE for over 50 years. No resources are required from the family to effect this result. The portfolio may be taxable if liquidated.
If perchance the Blacks also had an unincorporated business, the value of The Smith Manoeuvre leaps ahead if the Cash Flow Dam strategy is employed. Here is an example of the tax saved/reinvested, the years knocked off the mortgage, and the increased net worth for The Blacks in two cases. One is a very small company, which averages expenses of only $2,000 per month. The second example is a larger company with expenses of $10,000 per month.

Figure 3.2 Plain Jane Expenses of$2,000 per month Expenses of $10,000 per month
Taxes saved at 40% $41,980 $87,270 $96,687
Years saved 2.75 19.17 23.42
Net worth improvement $309,882 $718,927 $919,249

Summary

The basic Plain Jane version of The Smith Manoeuvre gives this average family with a $200,000 mortgage an improvement of more than $300,000 in their net worth. Adding the little known strategy of the Cash Flow Dam doubles and triples the already spectacular benefits of The Smith Manoeuvre for the Blacks in these two examples.
The Cash Flow Dam requires no new money and no new resources of any kind from the taxpayer. The benefits are free, and accrue as a result of reorganizing finances, just like wealthy people do.
The Cash Flow Dam does not work for incorporated companies because unlike unincorporated companies, the company is essentially considered another person for tax purposes. There are other ways an incorporated company can augment the performance of The Smith Manoeuvre but this is a discussion beyond the scope of this article. I can do no better than to once again suggest that you do yourself a disservice if you do not seek the advice of a financial planner or an accountant who is familiar with The Smith Manoeuvre.
My special thanks to Brian Dougherty, CA and Paul Winstanley, CA who taught me the Cash Flow Dam. Brian has been my beleaguered accountant for about a quarter of a century.

Brian Dougherty, CA and Paul Winstanley, CA perfected their tax skills at the prestigious accounting firm Thorne Riddell in the 70’s. Each now is in private practice and if you need the best, contact Paul in West Vancouver at (604) 922-3930 and (604) 986-7307 for Brian in North Vancouver.

My 2¢ worth is that I agree with you. CRA can use their general anti-avoidance clause and make your life a living hell.

The original Smith Manoeuvre is risky enough with all the leverage. This tax scam is much worse.

Fee Only Planner wrote:I personally think it likely wouldn't stand up in court.

I think CRA would challenge this if they see it. It's not invisible - you have to claim the interest on your T1 to get the benefit.

As soon as they see you are borrowing $10k personally, washing it through the business (which in this case is not even a separate legal entity), and then paying $10k against the mortgage on your principal residence, they will deny the deduction. You will go to court to challenge it and even the most laughably naive and incompetent Tax Court will see it as a sham transaction. I believe a real judge would see it the same way, but you never know with judges.

You also have to weigh the possibility of an attempt to impose GAAR, which the judge is almost certain to accede to.

And for what? I realize this is the North Shore, so the average house is worth a million bucks and might have a $500,000 mortgage. Suppose you can make the whole thing deductible using this dubious scheme. There's maybe $30,000 of interest every year, which is worth $13,000 a year max in BC. The typical person interested in this probably has a $200k mortgage, in which case it's worth maybe $5k a year.

IMO, audits and Tax Court and FCA appeals and Supreme Court appeals, with the GAAR hammer looming even if you did win, are neither fun nor free. For a few thousand a year, what's the point?

(Yeah, yeah, I know. This site is all about saving nickels where you can find them. It's also about not entering into dubious schemes where you get to foot the bill for being the test case. )

Norbert Schlenker wrote:I think CRA would challenge this if they see it. It's not invisible - you have to claim the interest on your T1 to get the benefit.

As soon as they see you are borrowing $10k personally, washing it through the business (which in this case is not even a separate legal entity), and then paying $10k against the mortgage on your principal residence, they will deny the deduction. You will go to court to challenge it and even the most laughably naive and incompetent Tax Court will see it as a sham transaction. I believe a real judge would see it the same way, but you never know with judges.

You also have to weigh the possibility of an attempt to impose GAAR, which the judge is almost certain to accede to.

And for what? I realize this is the North Shore, so the average house is worth a million bucks and might have a $500,000 mortgage. Suppose you can make the whole thing deductible using this dubious scheme. There's maybe $30,000 of interest every year, which is worth $13,000 a year max in BC. The typical person interested in this probably has a $200k mortgage, in which case it's worth maybe $5k a year.

IMO, audits and Tax Court and FCA appeals and Supreme Court appeals, with the GAAR hammer looming even if you did win, are neither fun nor free. For a few thousand a year, what's the point?

(Yeah, yeah, I know. This site is all about saving nickels where you can find them. It's also about not entering into dubious schemes where you get to foot the bill for being the test case. )

Norbert, that was pretty much my thoughts as well.

When I e-mail these thoughts to Mr Smith he suggested I read an IT on interest deductibility, which I did, but in the examples cited, none came close to this particular example. I personally would want an advanced ruling before I would even consider this scheme, and even then, the courts are not bound by such rulings.

The courts haven't used GAAR as much as many thought, but this would seem likely opportuity to do so.

However, having said all that, I'm not sure if there have been any similar cases before the courts, and if there has what the outcome as been.

[Restored from backup 2006-07-18]

Norbert Schlenker wrote: You will go to court to challenge it and even the most laughably naive and incompetent Tax Court will see it as a sham transaction. I believe a real judge would see it the same way, but you never know with judges.

You also have to weigh the possibility of an attempt to impose GAAR, which the judge is almost certain to accede to.

I'll be upfront and say that I have been too crazy busy to do anything more than give this a cursory read. I'll save commnents for later. But I will comment on this quote to say that structure if not everything, still means very much. There are many cases that attempt to make personal borrowing deductible. And many of them DO stand up in courts, although the results are often mixed.

I'm thinking of a case where a lawyer (IIRC) removes the partnership capital from his practice, pays down his house mortgage, reborrows and invests back into the practice. All occurred on the same day if memory serves. CRA denies mortgage interest deduction, but it is reversed on appeal. Structure and careful planning means a lot.

Expect a fight? Fair enough. A laughable sham that has no legs in court? NOT EVEN CLOSE!

Also, people go way too far in their GAAR concerns. Sure, GAAR exists. It's broad sweeping in wording. But courts have been somewhat hesitant to give it the broad sweeping effect in application that many feared/fear. In many respects the courts have somewhat harnessed its scope.

More to come on the actual transaction when I have time.

FOP, I guess that it is just commissioned advisors that are crazy busy this week? Isn't this supposed to be the busiest week of the year for advisors?

[/quote]FOP, I guess that it is just commissioned advisors that are crazy busy this week? Isn't this supposed to be the busiest week of the year for advisors? [/quote]

My busy season is different from most advisors. Most of the clients who require tax planning have already been in contact. Much of what I do is ensure the tax planning as smooth as possible between the individuals and their corporations.

But my busiest time of the year is now until the end of April as we prepare a couple of hundred tax returns. But regardless, there is always something to do.

I'm thinking of a case where a lawyer (IIRC) removes the partnership capital from his practice

It seems to me that using a lawyer's legal practice as an example does not reassure me that I should or want to go down a similar legal path.

George$ wrote:

I'm thinking of a case where a lawyer (IIRC) removes the partnership capital from his practice

It seems to me that using a lawyer's legal practice as an example does not reassure me that I should or want to go down a similar legal path.

I personally don't think the Lawyer example is has any bearing on the Smith Manoeuvre, especially as it pertains to swaping debt from a proprietor to an individual.

[Restored from backup 2006-07-18]

Fee Only Planner wrote:
I personally don't think the Lawyer example is has any bearing on the Smith Manoeuvre, especially as it pertains to swaping debt from a proprietor to an individual.

It wasn't offered as a precedent on the specific legal issues, but rather to reference a significant case where structure overrode form at the appeal level. Structure is very relevant, contrary to suggestions otherwise. In this case (and many others) the ruling recognized an individual's right to structure his affairs in a tax efficient manner, although the form of it was to create a tax deduction for what started out as non-deductible mortgage interest.

This IS very relevant to proposals such as the above. But that the case involved a lawyer is not at all relevant.

dagan, I believe "that lawyer" was Mr. Singleton - whose case helped define the current position on deductibility and whose ultimate victory (IIRC) prompted CRA to craft new, clearer rules on deductibility.

I'm really fuzzy on the details but I recall Singleton contributing some amount above $300k ($312k comes to mind) to his legal firm - then taking out ~$300k to finance the purchase of his new house. Or something like that. Even at the time I first heard of the case, it sounded like a risky move.

Hi, I had about $200K in mainly ETF's and Income Trust Units. I am 52 and will have an indexed pension when I retire at 60. Therefore, I only have bonds in my RRSP. (some backround). My partner has a house which I want to buy into and my 50% share coincidently comes out to $200,000. I have been using a form of the Smith Manuever and have been selling the stocks with gains (mainly TD Canadian Equity e-fund) to soak up a net capital loss carryforward so no taxes are payable. With the proceeds I am paying my girlfriend for my share of the house and borrowing the money on margin to buy back shares (mainly US index funds) to get my allocation back on target. The result will be stocks currently worth $200,000, a tax deductible loan of $200,000 and a half interest in a house worth $200,000. I will be using the tax refunds and income trust income to pay down the margin. Before reading Smith's book I would have just sold the stocks and bought into the house. I think (hope) I could weather a stock market meltdown. Any comments/suggestions??

silverfox wrote:I have been using a form of the Smith Manuever ...The result will be stocks currently worth $200,000, a tax deductible loan of $200,000 and a half interest in a house worth $200,000.

IIRC, the Smith maneuver involves a lot more fandangling. Seems to me you've simply sold equities, used the proceeds to buy a home and am now using an investment loan to replace the equities you sold. There's nothing new or novel about that -- it was even the subject of a court case called Singleton that Canada Revenue lost.

I think (hope) I could weather a stock market meltdown. Any comments/suggestions??

I think you'd better do more than hope. You're leveraging. Leveraging amplifies both upside and downside returns. Corrections can be very stressful; develop a strong stomach if you don't already have one. Use tax software such as QuickTax so you can clearly identify the tax savings attributable to the investment interest deduction and make sure you put that money against the outstanding principal. If you don't identify and direct those tax savings, they have a funny way of disappearing. You indicate you're also relying on income trust distributions to service the debt. Make sure the trusts you buy are high quality; trust distributions can and do get cut. One trust -- Home Energy -- has even gone bankrupt.

Here's the verdict on the Singleton case.

My principal residence secures a line of credit. Those funds go to investments and the interest is deductible. That's about as complicated an arrangement as I can manage!

worthy wrote:

Those funds go to investments and the interest is deductible. That's about as complicated an arrangement as I can manage!

But don't forget why you get the interest deductibility (Singleton notwithstanding).

Borrowing for investments including common shares
¶ 31. Where an investment (e.g., interest-bearing instrument or preferred shares) carries a stated interest or dividend rate, the purpose of earning income test will be met "absent a sham or window dressing or similar vitiating circumstances" (Ludco). Further, assuming all of the other requisite tests are met, interest will neither be denied in full nor restricted to the amount of income from the investment where the income does not exceed the interest expense, given the meaning of the term income as discussed in ¶ 10.

Where an investment does not carry a stated interest or dividend rate such as some common shares, the determination of the reasonable expectation of income at the time the investment is made is less clear. Normally, however, the CCRA considers interest costs in respect of funds borrowed to purchase common shares to be deductible on the basis that there is a reasonable expectation, at the time the shares are acquired, that the common shareholder will receive dividends. Nonetheless, each situation must be dealt with on the basis of the particular facts involved.

These comments are also generally applicable to investments in mutual fund trusts and mutual fund corporations.

Example 8

R Corp. is an investment vehicle designed to provide a capital return only to the investors in its common shares. The corporate policy with respect to R Corp. is that dividends will not be paid, that corporate earnings will be reinvested to increase the value of the shares and that shareholders are required to sell their shares to a third-party purchaser in a fixed number of years in order to realize their value. In this situation, it is not reasonable to expect income from such shareholdings and any interest expense on money borrowed to acquire R Corp. shares would not be deductible.

Example 9

S Corp. is raising capital by selling common shares. Its business plans indicate that its cash flow will be required to be reinvested for the foreseeable future and S Corp. discloses to shareholders that dividends will only be paid when operational circumstances permit (i.e., when cash flow exceeds requirements) or when it believes that shareholders could make better use of the cash. In this situation, the purpose of earning income test will generally be met and any interest on borrowed money to acquired S Corp. shares would be deductible.

Bruce wrote:

Use tax software such as QuickTax so you can clearly identify the tax savings attributable to the investment interest deduction and make sure you put that money against the outstanding principal. If you don't identify and direct those tax savings, they have a funny way of disappearing.

CRA's take on this:

First use or current use
¶ 17. Several decisions of the Supreme Court of Canada, notably Canada Safeway, Bronfman Trust and Shell, have made it clear that the relevant use is the current use and not the original use of borrowed money. In determining the current use of borrowed money, taxpayers must establish a link between the money that was borrowed and its current use.

Tracing/linking borrowed money to its current use¶
18. In simple situations where one property is replaced with another, such linking is straightforward. In these situations, the current use of the borrowed money is entirely with respect to the replacement property since all the proceeds of disposition from the original property are reinvested in the replacement property, as was the case in Tennant.

<snip>
Disappearing source rules
¶ 19. In general terms, the disappearing source rules in section 20.1 apply where borrowed money ceases to be used for the purpose of earning income (i.e., the borrowed money can no longer be traced to any income earning use). Generally, the borrowed money that is no longer linked to any income earning use is nonetheless deemed to be used for the purpose of earning income such that interest continues to be deductible for that portion of the borrowed money.

I have been asked by a few users about the SM, and although I don't know the intricacies, I decided to do a really simple study of how much you would be advantaged if somehow your mortgage interest was deemed tax deductable.

For a 45 year old earning 75K, with a $150K 20 yr mortgage, retiring at 65 and dying broke at 95, I get a roughly $1200 yearly advantage if the mortgage interest is tax deductable. .....a mere 3% advantage.

The question is,.... is this all there is to the SM, or is there some other (leveraged, say) strategy involved?

3% doesn't seem to be such a big deal, but I guess every little $1200 helps.

[This and the next message moved from Outstanding Financial Pornography by ModeratorA.]

Did anyone see Jon C's column today in the Financial Post (On the Smith manouvre)?

- ukridge.

It's interesting that Smith gets the main credit for the idea of using the equity tied up in your home via an investment equity loan or remortgage. However this concept was around since at least 1992 when it was propounded by Charles Givens in his book "Wealth Without Risk for Canadians" as Strategy #99. I implemented it that same year and have used it ever since to good effect.

Now it's been rediscovered by the investment planning crowd I just hope it stays that way.

I agree with Bruce: there's nothing per se "new" about this strategy. Even forgetting the investment loan part of it, it makes sense to pay off mortgage interest as quickly as possible. Some people may choose to do that first, THEN borrow to invest; more cautious people will pay off the mortgage and merely invest with the cash as they earn it (my personal preferred route). A variant is to sell off your non registered portfolio (if any), use the proceeds to wipe out or reduce the mortgage, then repurchase the securities with a deductible investment loan.

I reported on the meeting yesterday because it's clear that mortgage brokers and financial planners are jumping on this and word-of-mouth by customers has taken on some kind of critical mass. The planners etc. too recognize it's nothing particularly new but they see that Smith has packaged up the concept in a way that gives them an apparent "unique selling proposition."

Thanks Jon. I like this statement a lot better than the FP article. Although it was just a report on the meeting, I thought it came across as an endorsement of the scheme, without your usual notes of caution.

A casual reader and newbies may not realize the implied caveats. I don't have the newpaper on hand to cite the parts that made me uncomfortable.

- ukridge.

Well, I issued the caveats four years ago when I first reviewed the book. You can quibble with the 10% stated return, as I did then. You can argue much of the effect comes from paying down the mortgage, as most Canadians already know. No doubt this is another instance of "nothing new under the sun" -- all I was saying is that, warts or not, a lot of people are doing this and brokers and planners see a big opportunity.

P.S. I've synthesized these thread comments and added a few more points in the "blog" version of this at www.nationalpost.com/chevreau

Here's part of an earlier column I wrote on this two years ago:

I can't question the overall logic, although it's debatable whether average Canadians have the discipline and long-term foresight needed to make the manoeuvre successful.

My main quibbles are two-fold. Smith advocates maintaining the typical $200,000 mortgage debt in perpetuity, albeit gradually converting it from non-tax-deductible to tax-deductible status while building a non-registered investment portfolio. Personally, I prefer the security of having zero debt as quickly as possible, then building financial assets on an "invest-as-you-earn" basis.

The other problem I have with Smith's seminar is his overly optimistic assumption that financial markets will deliver 10% annual returns going forward.

Smith says that's the historic average going back 50 years but most financial planners I know use much more conservative projections like 6%.

True, Smith's software lets you plug in 6% or any other figure, but the seminars that get mutual fund prospects all hot and bothered are based on the optimistic 10% return.

Those are the kinds of projections that got the Universal Life sales people into trouble when the market turned south. Smith now says he will use 8% henceforth.

Of course, the book begins with a long one-page disclaimer that readers "seek the services of a competent professional with the required qualifications."

I'll second that.

Today's column (it's not "locked" to non subscribers) is a followup to the August piece which appears to be part of a marketing promotion for this strategy. Hopefully it should be clear that the part that I "recommend" is the basic act of paying down a mortgage. The "full" Smith -- including a leveraged investment loan -- is not necessary unless you're confident you have the risk tolerance to keep to the program when markets get volatile. Arguably most ordinary home owners are not in that category -- as Mastracci notes in the piece, just paying down the mortgage (assuming 7% interest, 25 year time horizon, 40% tax bracket) is equivalent to getting an 11.7% pre-tax return -- risk free.

Full piece at http://www.canada.com/nationalpost/index.html

(click down to columnists).

For the truly anal.... here is more than you need to know concerning the effect that the non-deductibility of your house mortgage has.

A 45 year-old earning 80K, retiring at 65 with 500K/500K in reg/nonreg (growth rate 7%) with a 7% 500K interest deductible 30 year mortgage needs to earn 8.13% on his investments (an extra 1.13%) over his lifetime in order to match the situation where his loan interest wasn't deductible.

Or, looking at it in terms of lifestyle..., the deductibility of his mortgage would mean he could enjoy another $7000 in after tax income for each of his remaining 50 years.... the govt would see (PV'ed) 426K vs 590K in total tax revenue.

Normal CPP/OAS, CPI 2%, die-broke 95, province BC.