Van Steenis – Tax Court of Canada finds that “return of capital” distributions by a mutual fund reduced the unitholder’s deductible interest

Graham J agreed with CRA’s position (in e.g., 2003-000082) that returns of capital received by a unitholder in a REIT or other mutual fund trust give rise to a change in the current use of the funds under the still-outstanding loan of the unitholder that had funded the units’ purchase. Thus, a taxpayer who had borrowed $300,000 to buy MFT units and received “return of capital” distributions totaling $200,000 over the following eight years (most of which were used for personal purposes) thereby lost over half of his interest deductions by the end of this period.

Graham J considered that it truly accorded with the scheme of the Act to characterize trust distributions in excess of the s. 104(13) income distributions as being returns of the unitholder’s capital, stating:

Subparagraph 53(2)(h)(i.1) reduces the unitholder’s adjusted cost base in the fund by the amount of capital distributed to him or her. … The fact that distributions of capital are not treated as income until they exceed the amount of a unitholder’s investment clearly indicates that Parliament viewed distributions of capital as being returns of the unitholder’s own investment.

The contrary viewpoint would emphasize the artificiality of treating such distributions, which are effectively deemed to be capital distributions only for capital gains computation purposes, as being truly a return of the investor’s capital (whose units might have an increasing rather than diminishing NAV.) Presumably, there would have been a different result if the borrowed funds had been used instead to invest in a public real estate company paying the same distributions (treated under s. 82(1) as 100% income), and which had not yet bothered to convert to a REIT because it was still fully sheltered (i.e., no taxable income).

Neal Armstrong. Summary of Van Steenis v. The Queen, 2018 TCC 78 under s. 20(1)(c)(i).