How to Justify Interest Deductibility in a Tax Audit

CRA may be taking a closer look at interest deductibility costs now that interest rates are higher and that line item on the tax return contains bigger numbers.  Tax deductible interest paid on money borrowed to earn investment or business income  must be justified with back up documentation that includes the demonstration of use of the funds, which is always more complicated with a line of credit, for example, has mixed personal and business/investment uses.  Here is what you need to know: 

Tracing/Linking.  The onus is on the taxpayer to trace funds to a current and eligible usage. However, CRA will accept a practical approach to determining the use of borrowed money and how it is redeployed. Taxpayers must demonstrate that aggregate eligible expenditures from co-mingled accounts, for example, must exceed the amount borrowed and deposited to that account.

Income-producing Accounts. CRA accepts that the use of borrowed money can be for an ancillary, rather than primary income-producing purpose. This will be determined as a question of fact.

Borrowing to Acquire Common Shares. Interest costs on money borrowed to purchase common shares will be deductible if there is a reasonable expectation that dividends will be received at the time the shares were acquired. If such is not the case, the interest will not be deductible.

Contingent Interests. Where income amounts are not payable because of an unpaid contingency, interest expenses incurred are not deductible.

Debts issued at a premium. Where no interest is stipulated to be payable, there is neither an interest deduction nor a capital loss since there is no disposition of property on the maturity of the debt.

Money borrowed to redeem shares or return capital. Interest will be deductible on money so borrowed if the capital replaced was previously used for an income-producing purpose.

Borrowing to pay dividends. The interest expense amounts will be deductible.

Borrowing to make interest-free loans. Interest may be deductible if the proceeds of the loan will be used to produce income.

Borrowing to make loans to employees and shareholders. Interest will be deductible if there is a reasonable expectation of income. This comes from the effort of the employee and such loans would be therefore viewed as a form of remuneration.

Borrowing to contribute capital. Interest may be deductible if the borrowed funds can be linked to an income-producing purpose (i.e. the issuing of dividends).

Borrowing for loss utilization. Interest expenses will be deductible if there is an ancillary purpose of earning income.

Borrowing to honor a guarantee. Interest costs are generally not deductible unless it can be shown that the transaction will increase the potential for dividends to be received. If the taxpayer receives consideration of some kind for fair market value (FMV), such amounts are a source of income and therefore, any interest expense incurred to earn it will be deductible.

Leveraged buy-outs. Interest on money borrowed to acquire common shares will be deductible. CRA comments further by saying there is no arm's length requirement in this case.

Limitation on Interest Deduction on Purchase of Undeveloped Land. S. 18(2) limits the deduction for interest and property taxes on land to the net income from the land. These limitations do not apply to land used in the course of business other than land development. Interest and property taxes not deductible as a result of S. 18(2) may be added to the cost base of the land (S. 53(1)(h)).

Interest Paid on Capital Property That is no Longer Owned. When a taxpayer borrows money to acquire a capital property for the purposes of earning income from that property and subsequently disposes of the property for an amount less than the amount borrowed to acquire the property, S. 20.1(1) deems that the taxpayer continues to use the property for the purpose of earning income from property. In other words, if the proceeds of the sale are used to pay back the money borrowed, then the interest payable on any outstanding balance will continue to be deductible.