Under the Income Tax Act, interest expense can be deducted from business income or property income if certain conditions are satisfied:
- There must be a legal obligation to pay interest. (In most cases this ensures that the recipient of the interest is required to report it as income.) An obligation to pay interest that is contingent or uncertain is disallowed. However, the legal obligation can be under an oral arrangement — provided the CRA or the Tax Court believes the obligation actually existed (e.g., Conrad Black v. The Queen, 2019 TCC 135).
- The amount deducted must be reasonable. If the borrowing is not at arm’s length (e.g., a loan from a family member) and the rate paid is higher than a commercially available interest rate, the CRA will normally disallow the excess.
- The interest is paid on borrowed money used for the purpose of earning income that is subject to tax. The CRA and the Courts generally require that the borrowed money can be traced this way. It is not enough to say that if you had not borrowed the money, you would have had to sell other assets that generate income. You need to show that the money you borrowed was directly used to invest in a business or in property that can generate taxable income.
- Alternatively, the interest can be paid on the unpaid purchase price of property that is used for the purpose of earning income from business or property (e.g., paying interest on a vendor takeback mortgage on a rental property). Again there needs to be a direct link between the property and the earning of income. (There are some other special cases where interest deduction is allowed as well.)
- The borrowed money, or the property, does not have to actually generate income, nor need it generate a profit after expenses. It has to be used with the intention of earning income. The Supreme Court of Canada ruled in the Ludco case (2001 SCC 62) that for shares, earning dividends need not be the primary purpose of the investment; an ancillary purpose is sufficient. The Court also ruled that an intention to earn some amount of income was sufficient, even though it was at a lower rate than was being paid out in interest.
- Traditionally, interest paid on borrowed money used to buy shares in a company was always considered to qualify, since shares can always pay dividends. However, in the Swirsky case (2014 FCA 36), the Federal Court of Appeal denied a deduction for interest on a loan used to buy family company shares, since the company had no history of paying dividends, so there was no “reasonable expectation of income”.
Special rules in the Income Tax Act prohibit deduction of interest on loans taken out for certain purposes, such as to make RRSP, RESP or TFSA contributions. As well, special anti-avoidance rules prevent interest from being deducted on a “leveraged annuity” or a “10/8” life insurance policy. (These were structures that were used before 2013 to take advantage of the interest-deductibility rules.)
As you can see, while the rules may sound straightforward, they can be hard to apply in practice. The above just touches briefly on the complexity of the interest deduction. If you are seeking to deduct interest, make sure that the funds you borrow are used directly to earn income that is reported on your tax return, and your deduction will normally be allowed.