When Can Businesses Deduct Interest Payments? A Primer from a Canadian Tax Lawyer

The Income Tax Act has rules that allow the deduction of interest in specific situations. Paragraph 20(1)(c) allows interest deduction for borrowed money used to generate business income or property income. Interest expenses on non-business and non-property loans, such as student loans, do not qualify for deduction. Additionally, deductions are not allowed on interest on loans to produce exempt income and loans for life insurance policies.

While paragraph 20(1)(c) allows the deduction, we have to look at the case law to understand the rules on the application of interest deductions. The Income Tax Act is complex. The addition of case law further adds to the complexity of this provision, and an experienced Canadian tax lawyer can help clarify your eligibility for interest deduction.

Establishing interest payments

Simply having interest payments for loans that produce business or property income is not enough to deduct the loan’s interest. In Shell Canada Ltd. v. Canada, the Supreme Court of Canada found that a taxpayer must show a bona fide lending agreement that refers to the payment as interest. If there is a bona fide lending agreement that refers to the payments as interest, then the taxpayer has to meet these four factors to deduct interest:

1. The amount must be paid in the year or be payable in the year in which it is sought to be deducted;
2. The amount must be paid pursuant to a legal obligation to pay interest on borrowed money;
3. The borrowed money must be used for the purpose of earning non-exempt income from a business or property; and
4. The amount must be reasonable, as assessed by reference to the first three requirements.

The most complex of these factors and the most difficult to prove is the third. This is where most issues regarding the deductibility of interest lie. The rest of this article will explore this third factor.

The purpose of earning non-exempt income from a business or property

The purpose of the borrowed money is determined when the investment is made. This requires looking at how the loan was used by the taxpayer.

The court in Ludco Enterprises Ltd. v. Canada stated that there are two factors that are crucial when making this assessment: (1) direct use of the borrowed money to earn income; and (2) whether the purpose of borrowing the money was to earn income. Both of these assessments are questions of fact and depend on each situation and its specific circumstances.

1. Direct use of borrowed money to earn income

The case of Singleton v. Canada outlines the first determination: whether a direct link can be drawn between the borrowed money and the source of business or property income. Simply put, if a link can be drawn from the borrowed money to the income source, then this past is met. A common example of this is getting a loan, then buying stocks in the same amount as that loan.

An example of an indirect link would be realizing a capital gain on property but not having the cash to pay the eventual tax on the realization. The individual might be forced to sell his or her dividend-paying stocks to pay for the taxes. If the individual takes out a loan and uses it to cover the taxes owed, then the taxpayer cannot deduct the interest expenses of the loan.

2. Purpose of earning income

The ‘purpose of earning income’ test was clarified in Ludco Enterprises Ltd v Canada. The purpose test looks at whether, considering all the circumstances, the taxpayer had a reasonable expectation of income at the time the investment was made.

This is based on an objective standard of a reasonable expectation. It does not depend on a taxpayer’s subjective intention on whether the investment will produce income. Importantly, this also does not rely on earning income as being the sole intention of the investment. A taxpayer can have another primary intention or have earning income as a small reason for the investment, and still have the purpose of earning income.

Pro tax tip – use s.20(1)(c) to your advantage

By borrowing to invest and using personal savings for non-deductible personal expenses, a taxpayer can maximize deductible interest and improve his or her after-tax return. This strategy allows taxpayers to limit the impact of interest costs by effectively shifting them into being tax-deductible. The one caveat is ensuring you properly structure your purchases to avoid the interest deduction being rejected by the CRA. A Canadian tax lawyer can help ensure this.

A common strategy that uses paragraph 20(1)(c) is:

1. selling your investments;
2. using the proceeds from the sale to pay down your mortgage;
3. getting a home equity line of credit for the same amount of the pay down;
4. borrowing the full amount and repurchasing the sold investments; and
5. deducting the interest under paragraph 20(1)(c).

Because the interest is being used to produce business or property income through investments, and there is a direct link, you will be able to deduct the line of credit’s interest.

FAQ

What if I make other transactions before using the borrowed money to generate business or property income?

Courts do not look at other transactions, such as spending non-loan money on a personal expense, then using the loan to buy assets. If you borrow $5,000, then decide to book a $5,000 vacation before buying $5,000 worth of shares, there is still a direct link as long as you purchase the shares.

Can I deduct interest on investments in a TFSA or RRSP?

No. Paragraph 18(1)(t) does not allow for interest deductions on investments made to a TFSA or RRSP. Paragraph 18(1)(t) overrides paragraph 20(1)(c); so, even if the factors above are met, a taxpayer cannot deduct the interest on investments in a TFSA or RRSP.

Can I deduct interest on borrowed money I lend out for an income-earning purpose?

Yes. However, taxpayers need to be cautious about whether the loan they provide earns interest. If the loan bears interest, then as long as the taxpayer has a purpose of earning income, he or she can deduct the interest on the borrowed money.

If a taxpayer is providing an interest-free loan, then the taxpayer must show that the loan was provided for the purpose of earning income in the future. In Canada v. Canadian Helicopters Ltd., the court found that borrowing money to provide an interest-free loan to help a corporation acquire another corporation, which would later benefit the loan provider, was sufficient to deduct interest.

Moreover, special rules in the Income Tax Act, such as attribution and imputed interest rules, can apply when loans are made to non-arm’s-length parties, which may reduce or eliminate the benefit of the deduction.

Disclaimer: This article provides broad information. It is only accurate as of the posting date. It has not been updated and may be out of date. It does not give legal advice and should not be relied on as tax advice. Every tax scenario is unique to its circumstances and will differ from the instances described in the article. If you have specific legal questions, you should seek the advice of a Canadian tax lawyer.

About the Author

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David J. Rotfleisch

David J. Rotfleisch, a leading Canadian tax lawyer, is not only a certified specialist in taxation but also a chartered professional accountant. Most recently, David is a pioneer in Canadian crypto taxation.

As of April 2020, he was one of 12 Ontario Certified Specialists In Taxation™.

Learn more about David J. Rotfleisch