As discussed above, interest expense is normally deductible if the borrowed money is used for the purpose of earning income from a business or property. In this regard, the courts have indicated that direct use of the borrowed money is required, and that an indirect use does not qualify.
To appreciate the distinction between a direct use and an indirect use, consider the following example.
You have $40,000 in cash. You would like to purchase $40,000 worth of mutual funds, and you are also thinking of buying a $40,000 car for personal use.
If you borrow $40,000 to buy the car, the direct use of the borrowing is not for the purpose of earning income. You cannot successfully argue that the borrowing indirectly allowed you to acquire the mutual funds (i.e. the borrowing allowed you to use your $40,000 cash to acquire the mutual funds). Interest on the borrowing is not deductible.
If instead you borrow $40,000 to buy the mutual funds, the direct use of the borrowing is for the purpose of earning income. You can then use your $40,000 cash to buy the car. Of course, this route of action makes more sense, since now the interest on the borrowing would be deductible.
The direct-use rule leads to some tax planning options and opportunities, particularly where you own some income-earning properties and are thinking of borrowing for personal purposes. You can liquidate some of the properties, use the cash for personal purposes and then borrow to reacquire the properties.
For instance, say you already owned $40,000 worth of mutual funds and were thinking of borrowing to buy a $40,000 personal-use car. You might consider selling the mutual funds, using the $40,000 proceeds to buy the car, and then borrowing to repurchase the mutual funds. In this case, the direct use of the borrowing would be an income earning purpose, and the interest on the borrowing would be deductible. (This plan works best if the mutual funds have little or no accrued capital gain, because any gain will be triggered when you sell the funds.) This type of tax planning has been approved by the courts, and most notably by the Supreme Court of Canada in 2001 in the Singleton case.