How to Reduce Borrowing Costs With Tax Efficiency

Ian Wood, CFP, CIM, MFA-P

After years of historically low interest rates, lending rates have risen dramatically since March 2022 with prime rates rising 2.25% in just over 4 months.  Many clients are now becoming more concerned about the impact rising rates will have on their cash flow and looking for ways to reduce their borrowing costs. One way is to be sure tax deductions for interest costs are maximized. Here’s how:

If the debt was incurred for the purpose of earning income, then it may be possible for the interest to be deductible against income, which, if set up correctly, can reduce the after-tax effective interest rates on debt. 

For example, a loan with a 10% interest rate with deductible interest for at taxpayer with a 40% tax rate, will have an effective after-tax interest rate of only 6%.  For this reason, debt with deductible interest is often referred to as “good debt” while debt without deductible interest is called “bad debt.” 

There are a few key features to consider when determining whether interest can be deductible against income.  CRA’s Income Tax Folio S3-F6-C1 discusses interest deductibility and expands upon the definitions within the Income Tax Act found in paragraph 20(1)(c).  From the folio: “Where money is borrowed, the use of the money must be established and the purpose of that use must be to earn income.”

This means that there are several uses of debt where the interest will not be deductible because they fail the purpose test.  Some common examples would be purchasing a home or personal use vehicle, or purchasing property the income from which would be exempt, such as RRSPs or TFSAs.

Borrowing funds to invest in common shares in a non-registered account may be eligible for the interest to be deductible if there is a reasonable expectation that the common shareholder will receive dividends or interest income.  This means that even if the corporation is not currently paying dividends or interest, the loan interest may remain deductible if it is reasonable to believe that the shares may receive eligible income in the future.  There may be situations where the corporation has asserted that it does not and will not pay dividends, in this case the interest is likely to be disallowed under the purpose test.  Generally, capital gains are not considered eligible income for the purpose test.

When looking to take advantage of interest deducibility for investments in non-registered accounts, clients often ask about the ability to write off interest on an existing debt, such as their mortgage, for an investment for which the loan was not directly used.  This, generally, will fail the usage test.

However, it may be possible through a series of transactions to change the non-deductible debt into “good debt” with deductible interest.  This is accomplished using a process known as the Smith Maneuver.  The full details of the Smith Maneuver are outside of the scope of this short article and clients should be referred to their tax advisor for more details, but essentially it is accomplished by paying off the debt and reborrowing specifically for the purpose of investing.  Often, this is done by selling the non-registered portfolio, paying off the debt, reborrowing the debt, then repurchasing the non-registered portfolio.

Regardless of whether interest is deductible or not, the after-tax interest rate is what should be compared.   If the interest rate on the new loan is significantly higher than the existing debt, then it may not make sense to go through the hassle.

Borrowing to invest, or leveraging, is considered a higher risk activity and is only suitable for clients with higher risk tolerances and understanding.  Because of the pitfalls that can occur with leveraging, clients may end up with debt with non-deductible interest while losing the underlying investment. 

Bottom Line:  A discussion with a qualified tax advisor is vital to ensure proper setup of the debt and investment to allow interest deductibility, while a comprehensive risk tolerance conversation is needed to ensure clients understand and are comfortable with the level of risk involved.

Ian Wood is Vice-President and Associate Portfolio Manager with Cardinal Capital Management in Winnipeg.  As a financial planner, he works directly with clients across Canada and the US, specializing in the areas of business succession, retirement income planning, and estate planning.