What Happens if the Liberals Attack the Smith Manoeuvre?

The Smith Manoeuvre has long been a popular strategy for Canadian homeowners seeking to convert their mortgage debt into tax-deductible investment debt. 

However, recent tax and regulatory changes have impacted the efficacy of the Smith Manoeuvre, and further changes from the Liberal government could pose additional challenges.

In my latest blog post, YouTube video and podcast episode I give an analysis of the current landscape and potential future threats to this investment strategy.

You’ll learn about:

• What tax & regulatory changes have happened that affect Smith Manoeuvre?
• What changes might the Liberals do that would attack the Smith Manoeuvre?
• Why is an attack on the Smith Manoeuvre possible?
• What are the 19 tax increases that affect investors?
• What additional tax increases might the Liberals be thinking of?
• Why are the Liberals continually increasing taxes?
• Is it likely that they would attack the Smith Manoeuvre?
• What happens if the Liberals Attack the Smith Manoeuvre?

Recent Changes Affecting the Smith Manoeuvre

Negative Impacts:

1. OSFI Rules: The Office of the Superintendent of Financial Institutions (OSFI) has introduced rules that reduce ongoing investments through the Smith Manoeuvre by about 20%. This reduction stems from tighter regulations on mortgage lending and interest deductibility.
2. Higher Capital Gains Inclusion: The increase in the capital gains inclusion rate reduces the benefit of the Smith Manoeuvre by decreasing the after-tax returns on investments.

Positive Impacts:

1. Higher Income Tax Rates: Paradoxically, higher income tax rates can increase the benefits of the Smith Manoeuvre. As tax rates rise, so do the tax refunds from interest deductions, enhancing the overall tax efficiency of the strategy.

Potential Liberal Policy Changes

If the Liberal government targets the Smith Manoeuvre, several policy changes could undermine its benefits:

1. Limiting Interest Rate Deductions: A significant threat is the potential limitation of interest rate deductions to match investment income, similar to the rules in Quebec. This would severely restrict the ability to deduct interest expenses.
2. Increased Investment Taxes:
   • 100% Capital Gains Inclusion: Increasing the capital gains inclusion rate to 100% would eliminate the preferential tax treatment of capital gains, making investment returns less attractive.
   • Higher Tax on Dividends: Increased taxes on dividends would reduce the after-tax returns on dividend-paying investments, further diminishing the benefits of the Smith Manoeuvre.

Historical Context of Liberal Tax Increases

The Liberal government has a history of implementing tax increases, particularly targeting investors and higher-income Canadians. This trend raises concerns about future policy changes:

• 2016: Increased tax rates for incomes over $200,000 to more than 50%, elimination of the Family Tax Credit, and new reporting requirements for the sale of principal residences.
• 2019: Introduction of the passive investments tax and the Tax on Split Income (TOSI) rules, and the implementation of the carbon tax.
• 2023: OSFI rules reducing interest deductibility, property flipping tax, and a ban on foreign ownership of property.
• 2024: Increase in the capital gains inclusion rate from 50% to 67%, new Alternative Minimum Tax (AMT) rules, stricter General Anti-Avoidance Rule (GAAR), and a 2% share buyback tax.

Additional Tax Increases on the Horizon

Speculation about further tax increases includes:

• GAAR Usage Expansion: The application of the General Anti-Avoidance Rule in more scenarios, potentially disallowing any transaction partly motivated by tax savings.
• Home Equity Tax: Discussions around implementing a tax on home equity.
• Wealth and Gift Taxes: Consideration of wealth and gift taxes, influenced by left-wing think tanks.

Motivation Behind Liberal Tax Increases

The Liberal government’s consistent tax increases can be attributed to several factors:

1. Political Strategy: Using tax policy to create divisions between different economic groups to garner political support.
2. Economic Philosophy: A left-wing approach aiming to redistribute income rather than focusing on economic growth.
3. Fiscal Needs: The need to address the government’s substantial debt and annual deficits.

Likelihood of an Attack on the Smith Manoeuvre

Despite these concerns, a direct attack on the Smith Manoeuvre appears unlikely:

1. Legal Protections: Interest deductions are specifically allowed in the Income Tax Folio S3-F6-C1, and new GAAR rules stipulate that they don’t apply to actions explicitly permitted.
2. Widespread Use: Interest rate deductions are a common business expense, making limitations impractical.
3. Limited Awareness: The Smith Manoeuvre is not widely known enough to serve as an effective political wedge issue.

Conclusion

The Smith Manoeuvre remains a valuable strategy for building a retirement nest egg over time without significant cash flow impacts. 

While regulatory and tax changes have reduced some of its benefits, the strategy still offers substantial advantages through investment returns. 

Even in the absence of tax benefits, the Smith Manoeuvre can be highly beneficial when implemented correctly over the long term.

For homeowners utilizing or considering the Smith Manoeuvre, staying informed about policy changes and adapting strategies as needed will be crucial to maintaining its benefits.

Ed