Understanding Interest Deductibility Under Canadian Tax Law
Earlier this month, the Canada Revenue Agency (CRA) updated its comprehensive folio on interest deductibility. While most of the changes may not directly impact the average taxpayer, the folio now includes references to recent case law on what constitutes the phrase, “for the purpose of earning income from a business or property.”
Key Criteria for Deducting Interest Expenses
Under the Income Tax Act, interest expenses are generally considered capital expenses and are not deductible unless specific conditions are met. These conditions include a legal obligation to pay interest and the reasonableness of the amount. Additionally, borrowed funds must be used to earn income from a business or property, which includes investment income.
Clarifying the ‘Earning Income’ Test
The updated folio emphasizes that “for the purpose of earning income from a business or property” does not include a reasonable expectation of capital gains, citing a 2017 Tax Court decision. This clarification addresses confusion among investors regarding the deductibility of interest on investments primarily aimed at generating capital gains.
Fortunately, the CRA adopts a lenient stance based on specific circumstances. For instance, if funds are borrowed to make an investment with a stated interest or dividend rate, the income-earning test will generally be met, allowing for interest deduction—provided no sham or similar vitiating circumstance is present.
Deductibility in Scenarios with Common Shares and Other Investments
In scenarios where investments do not carry a stated interest or dividend rate, such as common shares, the CRA generally allows for interest deductibility based on the expectation that dividends will eventually be received. However, if a corporation explicitly states that dividends will not be paid in the foreseeable future, interest on borrowed funds for such investments may not be deductible.
The CRA’s administrative position, as outlined in the folio, also extends to mutual fund investments. If a corporation remains silent on its dividend policy or states that dividends will be paid “when operational circumstances permit,” the income-earning test is satisfied, and interest will generally be deductible.
Case Examples from the CRA Folio
The folio provides two examples to clarify the CRA’s position:
Example 1: X Corp. is an investment vehicle designed solely for capital returns, with a policy of reinvesting earnings and requiring shareholders to sell their shares to realize value. In this case, interest on borrowed funds to acquire X Corp. shares is not deductible.
Example 2: Y Corp. raises capital through common shares and plans to reinvest cash flow. However, it discloses that dividends will be paid when operational circumstances allow. Here, the income-earning test is met, and interest on borrowed funds for Y Corp. shares is deductible.
Considerations on the ‘Current Use’ of Borrowed Funds
The folio also discusses scenarios related to the “use” of borrowed funds. According to various Supreme Court decisions, it is the current use of the funds—not the original purpose—that determines interest deductibility. For example, if an investment is sold and the proceeds are used to acquire another, the interest on the borrowed money remains deductible, provided it reflects the cost of the new investment.
What Happens if Your Investment Becomes Worthless?
A significant point covered in the folio is the “disappearing source” rules. Even if an investment, such as shares of XYZ Inc., becomes worthless or the company goes bankrupt, the interest on the outstanding loan can still be deductible. Under the tax act, the borrowed money is deemed to be used for the purpose of earning income, thus preserving the interest deductibility.
For further reading, consider checking out our article on Top Tax Deductions and Credits in Canada.