Turn personal debt into tax-deductible business debt with cash damming
HOW IT WORKS
Cash damming involves using the gross revenue generated by your business to pay off your personal debts. Then, to cover your ongoing business operating expenses, you use a separate line of credit or other loan facility used exclusively for business.
In effect, your personal debt is replaced by business debt, which makes the interest costs tax deductible.
ARE YOU ELIGIBLE?
Three main criteria determine your eligibility for this strategy:
• You must generate professional or business income through an unincorporated entity.
• You must incur professional or business expenses in order to generate your income.
• You must have personal debts.
To implement a cash damming strategy, you will need three separate bank accounts:
1. An account used only to deposit your gross business or professional income, and to pay off your personal debts.
2. An account used only to pay business expenses. Note that GST and PST collected from gross revenues should be deposited into this account.
3. A line of credit (or other loan facility) that you will use to replenish the second account as needed.
CASH DAMMING AT WORK
Let’s take the example of Dr. Green, the owner of a dental practice with two employees, and a house with a $220,000 open mortgage. This year, the gross annual income from his practice will be $300,000, and he’ll have business expenses of $125,000. After income tax, this will leave him with about $114,000 (assuming an average income tax rate of 35%).
However, if the dentist were to pay his business expenses using a separate (business) line of credit instead of his revenue, he’d have $125,000 in extra cash.
A WORD OF CAUTION
Before you pursue this strategy, there are some potential pitfalls to be aware of. For instance, repaying your mortgage or other debt ahead of schedule may trigger a penalty from your lender. You’ll want to review all the potential associated costs and benefits to ensure that cash damming will work for you.
In addition, it may be difficult to secure a large business line of credit unless you have sufficient Collateral.
THE CRA’S VIEW OF CASH DAMMING
At least for now, it seems unlikely that this tax-planning strategy would be challenged under the Income Tax Act’s General Anti-Avoidance Rules. In an income tax ruling published in February 2003 (F2002-018052) the Canada Revenue Agency (CRA) acknowledged cash damming as a legitimate strategy that would not be challenged. As with all tax planning, however, there’s a Possibility that tax legislation will change and render the strategy less effective.
In the meantime, to successfully employ this tax-planning strategy, meticulous bookkeeping is essential. Each bank account and credit line or debit instrument must be administered accurately in order to demonstrate to the CRA that the line of credit is for business purposes.
Note: The above information is based on the current and proposed tax law in effect as of the date of this article. The article is for information purposes only and should not be construed as offering tax or legal advice. Individuals should consult with qualified tax and/or legal advisors before taking any action based upon the information contained in this article.