Six Rules for Investors Re: Interest Expenses

Evelyn Jacks with Excerpts from EverGreen Explanatory Notes

Did you know that generally speaking, interest is considered to be a capital expense and is not deductible against other income unless it meets specific requirements in the Income Tax Act? To be deductible, the use and purpose of the money must be established as interest costs – and therefore the amount of the deductions may rise, so expect increasing scrutiny by the CRA.  The following six rules will help tax specialists determine whether interest costs may be attacked by the CRA and keep meticulous notes on individual client files to trace the source of the borrowings.

Remember at the outset that the use of the borrowed money will refer to the “current” use, rather than the original use, and may include an indirect use.  Where the amounts are borrowed for property, it must have an income-earning purpose.

While interest is not specifically defined in the Income Tax Act, it must meet three criteria:

• It must be calculated on a day-to-day accrual basis
• It must be calculated on a principal sum
• It must be compensation paid for the use of the principal sum

There must also be a legal obligation to pay the interest costs. 

We have identified six more common rules to discuss with clients below:

Rule #1. 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. Co-mingled uses must be carefully separated into those that are deductible and those that are not.

Rule # 2 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.

Rule # 3 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 some time after the time the shares were acquired. If such is not the case, the interest will not be deductible.

Rule #4 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.

Rule #5  Limitation on Interest Deduction on Purchase of Undeveloped Land

S. 18(2) of the Income Tax Act 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)).

Rule # 6 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 and the interest payable on any outstanding balance will continue to be deductible.

The “disappearing source” rules are similar: where borrowed money can no longer be traced to any income earning use, the borrowed money is deemed to be used for the purposes of earning income so that income continues to be deductible. This is relevant if the taxpayer, for example, lost the underlying original investment due to market volatility or collapse of the entity invested in.

For further information, see Income Tax Folio S3-F6-C1 and EverGreen Explanatory Notes.