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”. Nevertheless, the CRA’s position in Income Tax Folio S3-F6-C1 1.70 is unchanged despite Swirsky; no history of dividend payment is needed, and common shares are normally presumed to meet the test, but there are exceptions, such as a stated policy that dividends will not be paid.
There have been many decisions from the Courts on interest deductibility, on a wide range of fact situations. For example, even if the property acquired goes down in value, the interest deduction can continue: Tennant (Supreme Court of Canada, 1996 CanLII 218). However, a taxpayer borrowing money to lend at no interest to his own company may not qualify (Scragg, 2009 FCA 180; Keybrand Foods, 2019 TCC 161), or may qualify if the borrowing is linked to future income earnings (Canadian Helicopters, 2002 FCA 30). In Penn Ventilator (2002 CanLII 871), the Tax Court allowed a company to deduct interest paid on a note it issued to repurchase its own stock; and in Trans-Prairie Pipelines (1970), interest borrowed to redeem preferred shares was deductible. On the other hand, in the A.P Toldo Holding Corp. case (2013 TCC 416), interest on borrowed money used to redeem common shares to resolve a shareholder dispute was not deductible, as the company was a holding company and did not have a “financing and banking” business. So the Penn Ventilator rule may be quite restricted. In Black (2019 TCC 135), Conrad Black’s payment of a damage award was held to be an interest-bearing loan to his company that was jointly liable with him for the damages, so interest was deductible — even though the loan was not recorded in writing until much later.
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.)
For corporations, especially large corporations that are part of a multinational group there are also other restrictions on interest deductibility introduced very recently. These rules, such as the “excessive interest and financing expenses limitation” and the “hybrid mismatch rules”, do not normally affect individual taxpayers.
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.