TAX
ALERT
February 2013
INTEREST DEDUCTIBILITY
Julia A. Dean, CPA, CA, is a Tax Manager in the Peterborough office of Collins Barrow.
At some point in the lives of most individuals and
business enterprises, loan interest becomes a
significant annual expenditure. Not surprisingly,
its deductibility in computing income has been the
subject of many disputes between taxpayers and the
Canada Revenue Agency (CRA). And in countless
circumstances the Canadian courts, at all levels, have
been called upon to resolve those disputes. From a
tax perspective, interest deductibility is a relatively
complex area. This article highlights a few of the basic
issues and some of the less obvious rules.
Interest is a capital expenditure and is not deductible
unless permitted by a specific provision of the Income
Tax Act (the Act). In general terms, interest can be
deducted in computing a taxpayer’s income in a
particular year if it can be shown that the interest is:
▪▪ paid or payable in that particular year pursuant
to a legal obligation to pay;
▪▪ reasonable in the circumstances; and
▪▪ on account of borrowed money that was used
for accepted purposes.
In essence, “accepted purposes” means that the
borrowed money must be used for the purpose of
earning income from a business or property, or to
acquire property for the purpose of earning income
from the property or business. If a borrowing
satisfies these criteria, interest related thereto would
be deductible for tax purposes.
In many cases, the use test is relatively obvious. For
instance, if a corporation borrows money to acquire
inventory or to fund accounts receivable, clearly
those borrowings are made to earn income from
a business, and interest related thereto would be
deductible. Similarly, if an individual borrows money
to acquire shares of Bell Canada (for example),
the interest would be deductible in computing the
individual’s income.
The use test is two pronged, requiring that the direct
use and the current use be eligible. Taxpayers must
be able to trace a direct link between the borrowed
money and an acceptable purpose. By way of
example, consider an individual who borrowed money
to acquire shares of Bell Canada. If the individual
borrowed money from the bank and used those
specific funds to acquire the Bell shares, the interest
would be deductible. In addition, if the individual had
previously borrowed money to buy a home, then
sold the home and used the proceeds to acquire
Bell Canada shares, the interest should also be
deductible. Why? Because the current use of the loan
was to earn income from property and the CRA has
indicated in IT-533 that this is an acceptable current
use of the borrowed funds.
The safest way to ensure that the interest deduction
is not questioned by CRA is to repay the original loan
and borrow new funds to purchase the investment. If
the individual borrowed money to buy Bell Canada
shares, then sold the shares and used the proceeds
to buy a home, the interest would no longer be
deductible as the current use of the loan was not for
an acceptable purpose. In limited circumstances, a
portion of the interest may remain deductible if the
Bell Canada shares were sold at a loss as illustrated
below and as explained in paragraph 19 of IT-533.
Notwithstanding these general rules, the courts and
the CRA have considered a number of indirect uses
of borrowed funds that may still result in deductible
interest. Some examples are discussed below.
Replacement of capital
Generally, interest on borrowings to redeem shares,
to return capital to shareholders or partners, or to
pay dividends would be deductible, as the borrowing
replaces capital already employed for the purpose
of earning income from business or property. For
example, instead of using accumulated profits
(retained earnings) to purchase inventory, to fund
accounts receivable or to acquire capital assets,
assume a corporation pays dividends or redeems its
shares. Assume further that the corporation borrows
funds that are used to finance inventory, receivables
and/or capital assets in connection with a business.
In this sequence of transactions, it is arguable that
the direct use of the funds is to earn income from a
business, but it is also arguable that the main objective
is to facilitate a distribution to the shareholders. The
courts have ruled that, if the direct use of borrowed
funds fills the hole in the capital of a business from
the redemption of shares, the return of capital or the
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payment of dividends, such indirect use of the funds
is an eligible use for purposes of interest deductibility.
A taxpayer may restructure borrowings and the
ownership of assets and still meet the direct use
test. However, on a cautionary note, the CRA will
look to apply the general anti-avoidance provisions
of the Act if it considers such a restructuring to be
abusive. The Supreme Court of Canada considered
a prime example of an allowable restructuring in The
Queen v. John R. Singleton (2001 DTC 5533). In
that case, Mr. Singleton, a partner in a partnership,
received a full repayment of his partnership capital
account. Mr. Singleton used those funds to repay
the mortgage on his home, which at the time was
incurring interest that was not deductible for tax
purposes. He then remortgaged his home and used
the funds to contribute capital to the partnership.
The Supreme Court ruled that this re-contribution of
capital was an eligible direct use of borrowed funds
and allowed Mr. Singleton to deduct mortgage
interest on his personal tax return.
Loan from a corporate parent to a subsidiary
In some circumstances, a parent corporation
borrows funds for the purpose of making non-interest
bearing advances to a subsidiary (both corporations
resident in Canada). Interest on those borrowings
can be deducted by the parent corporation if it can
demonstrate that the interest-free loan had the
effect of increasing the income-earning capacity of
the related company, and therefore the ability to pay
dividends to the parent.
Borrowing to acquire shares from spouse
In some cases, it is possible to rearrange borrowings
and asset ownership to facilitate interest deductibility.
Consider a situation in which an individual, “Mr. A,”
owns 100% of a corporation, “B-Co.” Mr. A wishes to
sell 20% of B-Co’s share capital to Mr. A’s spouse,
“Mrs. A,” for income splitting purposes. Assume
the fair market value of the 20% interest in B-Co is
$200,000, and that the shares are qualified small
business corporation shares for purposes of the
capital gains exemption. Further, assume that Mr.
and Mrs. A have a $200,000 mortgage on their home
on which they pay non-deductible interest. In order to
avoid the income attribution rules (discussed in the
spring 2009 issue of Tax Alert), Mrs. A must give Mr.
A consideration for the fair market value of the shares.
Mr. A could borrow $200,000 and use the proceeds to
repay the mortgage. Mrs. A could borrow $200,000,
providing the home as security, and use the funds to
acquire a 20% interest in the shares of B-Co. In this
case, the direct use of the funds by Mrs. A would be
for the purchase of an income-producing property,
the shares of B-Co, and reasonable interest paid by
her would be deductible in computing her income. Mr.
A could use the proceeds from the disposition of his
shares to repay his loan. Mr. A would realize a capital
gain on the sale of his shares, which, subject to his
personal tax circumstances, could be sheltered from
income tax with his capital gains exemption.
The Supreme Court considered a similar fact scenario
in Lipson and Lipson v. The Queen (2009 DTC 5015).
The taxpayer in that case ultimately lost, but on
other grounds than the arrangement to convert nondeductible interest to deductible interest.
Investment sold at a loss and a portion of the
loan remains outstanding
It is not uncommon for taxpayers to find themselves
in a loss position with respect to investments,
particularly in recent years. Where assets are
sold and the proceeds are insufficient to repay
borrowings incurred to acquire those assets, interest
paid on the shortfall remains deductible even
though the borrowed funds have ceased to meet the
purpose test. For example, assume a corporation
borrows $100,000 to acquire shares of Encana for
the purpose of earning dividend income. Five years
later, the shares of Encana are sold, at a loss, for
$40,000, and at that time the balance of the original
loan is $75,000. The corporation would be entitled to
deduct interest on the original loan up to a maximum
of $35,000. This scenario assumes that the $40,000
proceeds were used to repay a portion of the original
loan. If the proceeds of the sale are used for other
purposes, the interest on that portion would only be
deductible if the use of those proceeds meets the
purpose tests set out in the Act. However, if the
proceeds are used, for example, to repay a noninterest bearing shareholder advance, the deduction
of interest would be limited to the interest on $35,000.
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Borrowing to honour a guarantee
The use of borrowed money to honour a guarantee
is not considered a direct income-earning use
unless:
▪ ▪the guarantor charged a guarantee fee to
the borrower; or
▪ ▪under the terms of the guarantee,
the guarantor acquires a claim on the
defaulting party for the amount of the
guarantee, and interest is charged.
In the absence of a guarantee fee, or interest
income on the claim on the defaulting party, the
guarantor realizes no income from the provision
of the guarantee. Therefore, interest on the money
borrowed to honour the guarantee would not be
deductible unless honouring the guarantee was an
eligible, indirect use of the borrowed funds. This
might be the case, for example, where a shareholder
guarantees corporate loans with the expectation
that, with the borrowed funds, the corporation’s
ability to pay dividends would be enhanced.
Again, this article is intended to highlight some
of the key areas of interest deductibility. It is not
intended as an exhaustive discussion. Contact your
Collins Barrow advisor for more information §
Collins Barrow periodically
publishes a Tax Alert for its
clients and associates. It is
designed to highlight and
summarize the continually
changing tax and business
scene across Canada.
While Tax Alert suggests
general planning ideas, we
recommend professional
advice always be sought
before taking specific
planning steps.
www.collinsbarrow.com
info@collinsbarrow.com
Editor:
Robert W. Rock, CPA, CA, CFP
rrock@collinsbarrow.com
613.768.7547
Clarity Defined.