This is one of the most common questions about The Smith Manoeuvre – is it legal? And the answer is yes.
Fraser Smith, my father, pioneered The Smith Manoeuvre in the mid-80’s when he became a financial planner in Vancouver, BC. He was interested in the fact that the Americans could deduct a good portion of their mortgage interest where we Canadians could not. So, he decided to figure out a way to level the playing field. Dad set about reading the Tax Act and assembling the numerous pieces of the puzzle from the areas of mortgage fact and theory, investing rules and taxation and came up with a process whereby Canadians could, in fact, deduct the interest related to their principal residence.
This strategy, The Smith Manoeuvre, enables a Canadian homeowner to convert their expensive, non-deductible mortgage interest to the tax-deductible variety. In turn, this lowers their tax bill and enables them to speed up the payout of their expensive mortgage while simultaneously building an investment portfolio – which otherwise wouldn’t exist – in order to secure their family’s financial future. And it is legal. If it were not, Canadians would not have been continuously implementing the strategy for close to forty years and there would not be two best-selling books published on it (never mind one).
The strategy relies on a fundamental tax principle that is older than you or me – the principle that if one borrows to invest with a reasonable expectation of generating income, one can deduct the interest from their income.
There is a difference between tax evasion and tax avoidance – tax evasion gets you a call from the CRA, but tax avoidance is allowed. In fact it is entrenched that we Canadians have the legal right to structure our financial affairs to our best tax advantage. And that is what The Smith Manoeuvre does. It allows us to minimize our tax bill to the extent we are legally allowed.
Fraser used to love to tell the story about the time when, many years ago, two CRA agents showed up at his office without an appointment. They informed dad’s assistant that they were there to speak with Fraser about ‘this Smith Manoeuvre’. Dad eagerly invited them to come in and sit down and he then put pen to paper explaining how and why it worked. Dad says at one point one of the agents leaned forward and asked, “will this work for a $70,000 mortgage?” He never heard from them again. So yes, it is legal – in fact, when we were actively advising we had clients who were police officers, lawyers, judges and even CRA employees.
Another question frequently asked is why the government would be willing to give so much tax relief to Canadians who implement the strategy. Well, not only is The Smith Manoeuvre legal, it is in fact actually encouraged in principle. What do I mean by that? The government wants us to invest. When we invest it is good for businesses because with this new investment, they are able to build plant and acquire product and inputs – and all these purchases get taxed. And when these businesses increase their profits due to the increase in production and efficiencies, the government gets to tax these profits. And if a business is in growth-mode, they need to retain existing employees and hire new employees, and these increased and new salaries can be taxed. So, in the end, if the government can incentivize Canadians to invest, they can increase their tax base. And one way to incentivize us to invest is to allow us to deduct the interest on money that was borrowed to invest.
Yes, The Smith Manoeuvre is legal.