Basic Rules on Interest Deductibility

Marco Iampieri B.A., JD, M.B.A - with excerpts from EverGreen Explanatory Notes

With recent interest rate hikes in the news, taxpayers will have more questions about the deductibility of interest costs.  Exactly when is interest fully deductible as a carrying cost or a business deduction? When does it form part of the capital cost of the property? Finally, when do new legislative proposals recently released by Finance Canada begin to restrict interest cost deductibility and for whom?  Here’s what you need to know to have more confident conversations between advisors and taxpayers:

With recent interest rate hikes in the news, taxpayers will have more questions about the deductibility of interest costs.  Exactly when is interest fully deductible as a carrying cost or a business deduction? When does it form part of the capital cost of the property? Finally, when do new legislative proposals recently released by Finance Canada begin to restrict interest cost deductibility and for whom?  Here’s what you need to know to have more confident conversations between advisors and taxpayers:

Except if specifically noted in the Income Tax Act, interest costs you may incur when money is borrowed to make an investment in a capital asset will generally not be deductible as a carrying charge on the tax return.

However, interest and other carrying charges will be deductible, when income from the property is earned or reasonably expected to be earned.  For the purposes of claiming carrying costs as a deduction on the personal tax return, this includes interest, dividends, rents or royalties, but specifically not capital gains.  Also, the income does not have to be earned in the same year that the interest is deducted.  There simply must be a potential for such income to be earned.

Interest costs on money borrowed to invest in a tax-exempt property or an interest in a life insurance policy are specifically not deductible. However, here too there may be a rare exception; for example, deductibility of interest paid on money borrowed to acquire an interest in a life insurance policy that is not an exempt policy, a prescribed annuity contract or an annuity contract acquired before December 2, 1982.  In this case the interest deductibility will be limited to income reported from these investments.

Interest paid on money borrowed and then used to provide employer and shareholder loans may be deductible if reasonable, but again limited to the income reported from the loans.

Recent Jurisprudence and Its Effect on Interest Deductibility

A Supreme Court of Canada case styled Ludco Enterprises Ltd., 2002 C.T.C. 95 (SCC) resulted in a review of the intent and application of the law surrounding interest deductibility. In this case, it was confirmed that when interest is paid on money borrowed to earn dividends, the amounts will be deductible even if those dividends were very low. In fact, the earning of dividends need not be the primary purposes of the loan; it is enough that the potential to earn income from the loan exists. The Court also pointed to gross and not net income as the important feature.

In another Supreme Court of Canada case, Singleton v. Canada, 2001 SCC 61, a mortgage was refinanced to produce a tax-deductible transaction when the taxpayer pulled money out of his partnership to acquire a home and then borrowed to reinvest in the partnership. Interest costs were deducted and allowed in this case, as a "direct link" could be found to an income-producing purpose.

As a result of these and other cases, in 2003, CRA set out its current interpretations on interest deductibility in Folio S3-F6-C1, outlining that the key issue in deductibility involves the direct and current use of the money borrowed and the identification of an income-earning purpose. 

The various scenarios around which interest deductibility is judged by the CRA, is discussed next.

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