The canada revenue Agency allows deductions for the carrying costs of certain investments. But not only is the area predictably complex, it’s also contentious. And anyone deducting these charges will probably be targeted for scrutiny by the taxman.

There are two reasons why investment carrying costs are frequent-ly queried, says Jamie Golombek, vice president of tax and estate planning at AIM Funds Management Inc. in Toronto. First, costs are very different from one taxpayer to another in terms of what is deductible; second, the costs are straight deductions from income rather than credits. As a result, he adds, “They can have a significant impact on a client’s return.”

The area is a hot button with the CRA because it’s an easy one on which to focus its auditors and because people make a lot of ineligible claims, either through ignorance of the rules or uncertainty over what qualifies, says Kim Moody, a partner with accounting firm RSM Richter LLP in Calgary.

Investors can claim fees paid to manage their non-registered investments, but not for their RRSP or RRIF holdings. They may also deduct fees paid for safekeeping of investments and fees for certain types of investment advice, but not trading commissions or fees for financial planning advice.

They can also claim the interest paid on money borrowed to invest, as long as the investments are intended to produce income, including interest and dividends — not just capital gains.

Given the likelihood of increased scrutiny on these claims, it’s critical to ensure that these deductible carrying costs are well documented.

“If there is one thing clients would want, should CRA review their interest and carrying charges claims, it is to keep a proper paper trail,” says Aurèle Courcelles, senior specialist in tax and estate planning with Investors Group Inc. in Winnipeg.

And with the easy availability of personal finance software — and financial firms’ efforts to enhance their reporting to clients — that’s easier than ever. Moody has seen improvements in brokerage account statements over the past few years that should make it fairly straightforward for clients to document these costs.

Golombek agrees that investment dealers’ statements are generally good enough for the CRA, as these expenses are typically drawn right out of the account by the firm. (For margin or fee-based accounts, there are no cancelled cheques to send on to the CRA to prove these fees were paid; an account statement will suffice.)

Meanwhile, Moody suggests, clients can use a basic accounting program such as Quicken to keep track of these costs on an ongoing basis. If clients are not diligent enough to record these expenses themselves, he recommends hiring someone to do it — a modest expenditure that could save plenty of hassle at tax time. And even with decent evidence of these costs, he suggests clients take their records to a tax expert to ensure that they are claiming deductions for allowable items.

Compared with other carrying charges claims, the interest expense claim is likely to require more in-depth documentation to satisfy the CRA, Courcelles says. If the CRA does review a claim, the client should be able to produce documentation that supports the basic terms of the transaction: the date the loan was granted; the total amount of the loan; the amount of interest paid during the year; the amount of principal paid in the year; the principal amount outstanding at both the start and the end of the calendar year; and the details of the investments that the loan is being used to finance, such as name, quantity, purchase price and acquisition date.

As a result, advisors should remind their clients to keep their annual statements of interest with their copies of their tax returns, in case the CRA requests the statements, Courcelles adds.

“Advisors should instruct their clients who are borrowing to invest to keep information from the original date of the loan until the year of final repayment is statute-barred, which is three years from the date of the assessment,” he says. “Documents showing payment for carrying charges should also be kept until the year in which the deduction is claimed is statute-barred.”

The process of determining the deductible amount of interest expenses becomes more complicated if part of the loan is used for things other than investments, such as to pay personal expenses. In those cases, advisors should instruct their clients to clearly itemize their investment purchases and show how they calculated the associated interest expenses that are being claimed, Courcelles says.

@page_break@“If a client purchases both personal items and investments with the same line of credit, they will need to pro-rate their interest deduction accordingly — in the same manner as the ratio of business borrowings to personal,” says Sandy Cardy, vice president of tax and estate planning services with Mackenzie Financial Corp. in Toronto.

Although it’s the clients who will ultimately have to explain their actions, Courcelles says, advisors can also expect that clients may turn to them for help in the event that the CRA comes knocking. With that prospect in mind, he suggests that advisors, too, should have all the necessary documentation in their files.

As carrying costs are one area the CRA most frequently queries, Golombek says, it’s important that advisors — or their assistants — are well versed in quickly retrieving this information from their systems for their clients. Most firms send this stuff out routinely at the end of the year, but, if they don’t, the advisor should be able to access it quickly.

Claiming investment carrying costs may be a complicated and contentious issue for the CRA, but diligent, accurate record-keeping should be enough to keep its auditors at bay should the taxman question a claim. IE