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Deductibility of Interest Expense
Brian J. Arnold and Tim Edgar*
P RÉCIS
Un survol des aspects fondamentaux de la structure de la déduction des
intérêts est présenté dans cet article. L’historique des règles actuelles, en
particulier l’alinéa 20(1)c), ainsi que la raison pour laquelle les frais
d’intérêt diffèrent des autres dépenses y sont examinés. Le point central
de l’article est un examen des trois principaux éléments de la déduction
des intérêts :
1) la définition du terme «intérêts»;
2) le critère sur l’utilisation directe ou sur l’appariement; et
3) le moment de la déduction.
Cet examen constitue le cadre d’une analyse de plusieurs propositions
visant la réforme de la déduction des intérêts, y compris l’abrogation de
l’alinéa 20(1)c), l’adoption d’une définition réglementaire complète des
intérêts, les modifications des dispositions relatives à la capitalisation
restreinte, l’adoption de règles plus complètes sur la capitalisation et les
restrictions sur la déduction des intérêts sur de l’argent emprunté pour
gagner un revenu imposé à taux privilégié. Les auteurs concluent qu’une
réforme complète de la déduction des intérêts est peu probable et
malvenue. Une méthode spéciale, différentielle est préférable.
ABSTRACT
This article presents an overview of the basic structural aspects of the
deduction of interest. It reviews the historical background to the current
* Brian J. Arnold is of the Faculty of Law, The University of Western Ontario, London,
and is associated with Goodman Phillips & Vineberg, Toronto. Tim Edgar is of the Faculty
of Law, The University of Western Ontario. This article is an amalgam of several articles
that we have published, both jointly and individually, over the last five years. See, in
particular, Brian J. Arnold, “General Report,” in International Fiscal Association, Cahiers
de droit fiscal international, vol. 79a, Deductibility of Interest and Other Financing Charges
in Computing Income (Deventer, the Netherlands: Kluwer, 1994), 491-541; Brian J. Arnold,
“Is Interest a Capital Expense?” (1992), vol. 40, no. 3 Canadian Tax Journal 533-53;
Brian J. Arnold and Tim Edgar, “The Draft Legislation on Interest Deductibility: A Technical and Policy Analysis” (1992), vol. 40, no. 2 Canadian Tax Journal 267-303; Brian J.
Arnold and Tim Edgar, “Interest Deductibility,” in Roy D. Hogg and Jack M. Mintz, eds.,
Tax Effects on the Financing of Medium and Small Public Corporations (Kingston, Ont.:
John Deutsch Institute for the Study of Economic Policy, 1992), 59-78; and Tim Edgar and
Brian J. Arnold, “Reflections on the Submission of the CBA-CICA Joint Committee on
Taxation Concerning the Deductibility of Interest” (1990), vol. 38, no. 4 Canadian Tax
Journal 847-85.
o 5 5 / no 5
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DEDUCTIBILITY OF INTEREST EXPENSE
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statutory rules, in particular paragraph 20(1)(c), and examines why
interest expenses are different from other expenses. The central focus of
the article is a discussion of the three major elements in the deduction of
interest:
1) the definition of interest,
2) the direct use or tracing test, and
3) timing.
This discussion forms the background for an analysis of several
proposals for reform of the interest deduction, including the repeal of
paragraph 20(1)(c), the adoption of a comprehensive statutory definition
of interest, changes to the thin capitalization rules, the introduction of
more extensive capitalization rules, and restrictions on the deduction of
interest on borrowed money used to earn preferentially taxed income.
The authors conclude that comprehensive reform of the interest
deduction is both unlikely and ill advised. An ad hoc, incremental
approach is preferable.
INTRODUCTION
It might be expected that the deductibility of an expense as common and
significant as interest would have been settled long ago. Nothing could be
further from the truth. Indeed, several fundamental aspects of the deduction of interest remain unsettled. This article provides a general review of
past and potential developments regarding the deductibility of interest in
Canada. First, we describe the statutory basis for the deduction of interest
from the adoption of a federal income tax in 1917 to the present. Then we
review the basic framework of the interest deductibility rules as developed by Parliament and the courts over the past 50 years. This review is
not intended to be a comprehensive description or analysis of the state of
the law on interest deductibility; instead, the focus is on the broader
structural aspects of the current rules under the Income Tax Act. 1 Against
this background, we discuss a number of outstanding policy issues and
potential legislative developments, some of which have been debated in
the past.
Two important themes are evident at the outset. First, except for the
apparently ill-fated Department of Finance study stemming from the Supreme Court of Canada’s decision in The Queen v. Bronfman Trust,2 the
deduction of interest expense has never been considered comprehensively
by the government. There have been brief episodes in which particular
aspects of interest deductibility have been debated: for example, the
1 RSC 1985, c. 1 (5th Supp.), as amended (herein referred to as “the Act”). Unless
otherwise stated, statutory references in this article are to the Act.
2 87 DTC 5059; [1987] 1 CTC 117 (SCC).
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restricted interest expense proposal in the November 1981 budget;3 the
December 20, 1991 draft legislation4 dealing with interest on money borrowed to make a distribution; and the comments of the auditor general in
his 1992 report 5 on the deductibility of interest and foreign source income. For the most part, however, taxpayers, tax advisers, and the
Department of Finance appear to be satisfied with the status quo. Any
fundamental changes are unlikely.
Second, the rules governing the deduction of interest have been developed through a process of ad hoc, incremental reform. More often than not,
problems requiring correction or clarification have been raised and addressed in court cases. In fact, the predecessor to paragraph 20(1)(c)—the
statutory basis for the deduction of interest—was enacted in response to
such a problem. More recent examples are the December 1991 draft legislation providing a deduction for interest on borrowed money used to make
a distribution and section 20.1 providing a continuing interest deduction
where a source of income ceases to exist. In our opinion, the government
should continue to follow this incremental approach to the design of the
rules governing the deductibility of interest. The idea of designing a comprehensive statutory package that addresses all aspects of the deductibility
of interest expense is appealing, in theory, but exceedingly difficult to implement and potentially disruptive of commercial transactions. Although
many fundamental policy issues remain unresolved, taxpayers appear to
have adapted to the deficiencies in the law reasonably well.
STATUTORY BASIS FOR THE DEDUCTION OF INTEREST
AND RECENT LEGISLATIVE DEVELOPMENTS
The first and most fundamental question to be asked concerning the deduction of interest is why it should be treated differently from other
expenses. All income-earning expenses, including interest, should be deductible; all other expenses should not be deductible, because they
represent a cost of personal consumption. However, interest expense has
been treated differently from other expenses for Canadian tax purposes.
The most significant difference is the specific statutory authorization for
the deduction of interest. Paragraph 20(1)(c) allows a taxpayer to deduct
interest with respect to borrowed money or the unpaid purchase price of
property if the money or property is used to earn business or property
income that is not exempt from tax. This statutory basis for the deduction
of interest is based on the premise that interest would otherwise be considered a non-deductible capital expense.
3 Canada, Department of Finance, 1981 Budget, Supplementary Information and Notices of Ways and Means Motions on the Budget, November 12, 1981, 25 and 61 (resolution
23), and 1981 Budget, The Budget in More Detail, November 12, 1981, 37.
4 Canada, Department of Finance, Draft Legislation To Amend the Income Tax Act and
Related Statutes, December 20, 1991 (herein referred to as “the draft legislation”).
5 Canada, Report of the Auditor General of Canada to the House of Commons 1992
(Ottawa: Supply and Services, 1992), 46-51.
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Originally, the Income War Tax Act, 19176 made no specific reference
to the deduction of interest. Tax was imposed on income, which was
defined as “net profit or gain.”7 This language implied that all expenses,
including interest, were deductible if they were incurred in earning profit.
Without any specific reference to the deduction of interest, however, this
conclusion was not entirely clear, particularly with regard to interest on
money borrowed to buy fixed assets.8 Although there was no specific
prohibition on deductibility, interest may not have been deductible either
because it was a capital expense or because it was a payment out of profit
after it had been earned (analogous to a dividend) and was not an expense
incurred in earning profit.
These kinds of concerns, highlighted by some UK cases,9 led to the
enactment of a specific statutory provision authorizing the deduction of
interest. In 1923, the minister of finance, the Honourable W.S. Fielding,
introduced an amendment to the Income War Tax Act adding an express
deduction for interest expense incurred in respect of a business equal to
the lesser of the stated rate of interest and an amount deemed reasonable
by the minister.10 In the House of Commons, the minister explained that
the amendment was necessary to distinguish between deductible and
non-deductible interest expenses and to prevent fraud by limiting the
deduction to a reasonable rate.11 At the same time, prohibitions on the
deduction of capital outlays and expenses not incurred for the purpose of
earning income were added to the Act.12 These prohibitions were intended
to clarify the existing law, not to change it. 13 At the time, profit was
6 SC
1917, c. 28.
section 3(1).
8 Charles Percy Plaxton and Frederick Percy Varcoe, A Treatise on the Dominion Income Tax Law (Toronto: Carswell, 1921), 209.
9 These cases are discussed in Brian J. Arnold, “Is Interest a Capital Expense?” (1992),
vol. 40, no. 3 Canadian Tax Journal 533-53, at 540-42.
10 SC 1923, c. 52, section 2 provided:
Subsection one of section three of the said Act is amended by adding thereto the
following:
(h) such reasonable rate of interest on borrowed capital used in the business to
earn the income as the Minister in his discretion may allow notwithstanding the rate
of interest payable by the taxpayer. To the extent that the interest payable by the
taxpayer is in excess of the amount allowed by the Minister hereunder, it shall not
be allowed as a deduction. The rate of interest allowed shall not in any case exceed
the rate stipulated for in the bond, debenture, mortgage, note, agreement or other
similar document, whether with or without security, by virtue of which the interest
is payable.
11 Canada, House of Commons, Debates, June 27, 1923, 4494, statement of the Honourable W.S. Fielding, minister of finance.
12 SC 1923, c. 52, section 3, adding section 3(8)(b), which provided as follows:
(b) any outlay, loss or replacement of capital or any payment on account of
capital or any depreciation, depletion or obsolescence, except as otherwise provided
in this Act.
13 Supra footnote 11, at 4492.
7 Ibid.,
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computed in accordance with commercial principles under which capital
expenditures and personal expenses were not deductible.14 Therefore, by
1923, the basic statutory structure for the deduction of business expenses
generally, including interest, was in place. In a fundamental sense, this
structure has remained unchanged.
The immediate predecessor of paragraph 20(1)(c) was enacted in 1948;15
it modified the first deductibility provision in several respects:
• the deduction was restricted to the lesser of the interest paid or
payable and a reasonable amount;
• the deduction of interest on money used to earn exempt income was
denied;
• interest was deductible on a paid or payable basis;
• the interest had to be paid or payable pursuant to a legal obligation;
• ministerial discretion was eliminated; and
• the deduction was expanded to include interest expense incurred for
the purpose of earning income from property as well as a business.
The many amendments and additions to the basic statutory provisions
governing the deduction of interest have generally been adopted in response to specific problems and have not affected the essential elements
of the statutory structure adopted in 1923 and revised in 1948. As noted
earlier, the current statutory regime is thus the result of an incremental
reform process. After 1948, the major changes to the basic deductibility
rules included the following:
• In McCool,16 the Supreme Court held that a corporation that purchased
timber, partly for cash and partly for a note, could not deduct interest on
the note. This result followed from the conclusion that under the 1923
provision interest on borrowed money did not include interest on the unpaid purchase price of property. This anomaly17 was rectified in 1950 when
the predecessor of subparagraph 20(1)(c)(ii) was introduced18 to permit
the deduction of interest on the unpaid purchase price of property. 19
14 Herbert A.W. Plaxton, The Law Relating to Income Tax of the Dominion of Canada
(Toronto: Carswell, 1939), 95.
15 SC 1948, c. 52, section 11(1)(c).
16 Minister of National Revenue v. T.E. McCool Ltd., 49 DTC 700; [1949] CTC 395
(SCC).
17 Canada, House of Commons, Debates, May 18, 1950, 2601, the Honourable Douglas
Abbott, minister of finance.
18 SC 1950, c. 40, section 5.
19 Section 11(1)(c)(ii) provided:
(ii) an amount payable for property acquired for the purpose of gaining or producing income therefrom or for the purpose of gaining or producing income from a
business (other than property the income from which would be exempt).
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• A minor wording change was introduced in 195420 to clarify that the
denial of a deduction for interest in respect of borrowed money used to
earn exempt income applied to income from both business and property.
In addition, the predecessor of paragraph 20(1)(d) was added, authorizing
the deduction of compound interest. 21 Since compound interest is payable
in respect of unpaid interest rather than borrowed money or the unpaid
purchase price of property, it was not otherwise deductible. 22
• In 1967, the deduction was extended to interest on amounts received
under the Appropriation Act for the purpose of advancing or sustaining
the technological capability of Canadian manufacturing or other industry,
and amounts received under the Northern Mineral Explorations Assistance Regulations to assist exploration for oils and minerals in northern
Canada. 23 Grants received under these programs were required to be repaid with interest if the recipient sold or used commercial products
resulting from the research project or if the exploration project became
successful.
• A further restriction on the deduction of interest was added in 1969
to prohibit the deduction of interest on borrowed money used to acquire
an interest in a life insurance policy or in respect of the unpaid purchase
price of an interest in a life insurance policy. 24
• Tax reform in 1972 did not result in any significant changes to the
deduction of interest. 25 However, in a related change, the definition of
“exempt income” in subsection 248(1) was altered to delete the reference
to intercorporate dividends, thereby permitting the deduction of interest
on borrowed money used by a corporation to acquire shares of another
corporation. This amendment was introduced to permit Canadian corporations to compete with foreign competitors, mainly US corporations, that
were able to deduct interest expense incurred in respect of the acquisition
of shares of Canadian corporations.26
• Subparagraph 20(1)(c)(iv) was added in 198327 to permit the deduction of interest on annuity contracts under section 12.2, which requires
the holders to recognize interest income on an accrual basis. A specific
20 SC
1953-54, c. 57, section 2(1), amending subparagraph 11(1)(c)(i).
section 2(2), adding paragraph 11(1)(a).
22 See Stock Exchange Building Corporation Ltd. v. MNR, 55 DTC 1014; [1955] CTC 5
(SCC).
23 SC 1966-67, c. 91, section 3(1), adding subparagraph 11(1)(c)(iii).
24 SC 1968-69, c. 44, section 2(1).
25 SC 1970-71-72, c. 63 (Bill C-259).
26 For a criticism of this amendment, see Gordon Bale, “The Interest Deduction To
Acquire Shares in other Corporations: An Unfortunate Corporate Welfare Tax Subsidy”
(Winter 1981), 3 Canadian Taxation 189-202. The case in favour is set out in Allan R.
Lanthier, “Policy or Abuse? The Auditor General’s Report” (1993), vol. 41, no. 4 Canadian Tax Journal 613-38, at 626-28.
27 SC 1980-81-82-83, c. 140, section 12(1).
21 Ibid.,
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provision for such contracts is necessary because both subparagraphs
20(1)(c)(i) and (ii) preclude the acquisition of a life insurance policy as
an eligible income-earning use, and annuity contracts are included in the
definition of a life insurance policy under the Act.
In a press release accompanying the June 2, 1987 notice of ways and
means motion 28 addressing several issues raised by the Bronfman Trust
case, the minister of finance indicated his intention to deal with the interest deduction on a comprehensive basis. Since that time, however, the
impetus for a comprehensive review of the interest deductibility rules has
waned, and a study of this kind no longer seems to be a priority of the
Department of Finance. Recent legislative initiatives are consistent with
the familiar pattern of incremental reform and include the following:
• On December 20, 1991, the minister of finance issued draft legislation implementing the notice of ways and means motion responding to
the Supreme Court of Canada’s decision in Bronfman Trust. As described
below, the decision cast some doubt on Revenue Canada’s administrative
practices permitting the deduction of interest in four circumstances where
the indirect use of borrowed funds is for the purpose of earning income,
even though the direct use is arguably not.
• Subsection 18(9.1), enacted in 1991,29 permits the deduction of certain bonus, penalty, and rate reduction payments as prepaid interest.
Although these payments function economically as interest surrogates,
they are not within the concept of interest developed by the courts and
would otherwise be considered non-deductible capital payments.
• Effective after 1991,30 subsection 18(9.2) prevents the deduction of
an excessive amount of interest on certain long-term debt obligations
involving substantial prepayments of interest. The provision effectively
treats such payments as repayments of principal.
• Enacted in 1993,31 subsection 16(6) and regulation 7001 address the
tax treatment of indexed debt obligations, which are defined in subsection
248(1) as debt obligations providing for an adjustment to an amount payable determined by reference to a change based on the purchasing power
of money. These amounts are deemed to be interest, even though they
take the form of additions to the principal amount of a debt obligation.
Indexed debt obligations are thus treated in the same way as conventional
debt obligations, which normally provide an increase in the nominal rate
of interest to compensate creditors for any loss in value of the principal
sum attributable to inflation.
28 Canada, Department of Finance, Notice of Ways and Means Motion To Amend the
Income Tax Act, June 2, 1987 (herein referred to as “the notice of ways and means
motion” or “the notice”).
29 SC 1994, c. 7, schedule II (SC 1991, c. 49), section 13(6).
30 SC 1994, c. 7, schedule VIII (SC 1993, c. 24), section 8(6).
31 SC 1994, c. 7, schedule VIII (SC 1993, c. 24), section 7(2).
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• Section 20.1, enacted in 1994,32 permits a taxpayer to deduct interest
with respect to an income-earning property, other than real property, even
though the source of income has ceased to exist. A similar deduction is
provided where the business of a taxpayer ceases to exist and borrowed
money or the unpaid purchase price of property used to earn income from
the business remains outstanding. The addition of section 20.1 reverses a
long line of cases holding that interest expense ceases to be deductible
when the related source of income disappears.33
BASIC STRUCTURAL ASPECTS OF THE INTEREST
DEDUCTION
Case law and statutory amendments over the past 50 years have consistently focused on three basic structural aspects of the deduction for interest
in paragraph 20(1)(c) and its predecessors:
1) The definition of interest for income tax purposes. Under the current law, it is often critical whether a particular amount is characterized
as interest because only interest is deductible under paragraph 20(1)(c).
Other financing expenses may or may not be deductible under other
provisions.
2) The use test. It seems clear that the deduction of interest should be
restricted to interest in respect of borrowed money or property used for
the purpose of earning income. Many questions arise, however, regarding
the proper approach to the application of this test. Although tracing the
use of borrowed funds is generally considered to be the required approach, the precise meaning of tracing is unclear.
3) The timing of the interest deduction. Timing issues related to interest deductibility are ubiquitous. They arise with respect to prepayments,
discounts, and premiums, and, more generally, the deduction of interest
incurred to earn income that is deferred.
Definition of Interest
The definitional issues that arise under paragraph 20(1)(c) and its predecessor provisions are largely the result of the adoption by the courts of a
restrictive concept of interest for income tax purposes. In response to this
restrictive concept, the government has enacted several specific provisions permitting the deduction of certain financing expenses that are
32 SC
1994, c. 21, section 13.
a discussion of these cases, see R.C. Strother, “Income Tax Treatment of Financing Charges,” in Income Tax Considerations in Corporate Financing, 1986 Corporate
Management Tax Conference (Toronto: Canadian Tax Foundation, 1986), 81-139, at 99-101;
and Edwin C. Harris, “Deductibility of Interest: Recent Developments,” in Report of Proceedings of the Forty-Fifth Tax Conference, 1993 Conference Report (Toronto: Canadian
Tax Foundation, 1994), 29:1-28, at 29:7-13. The policy case for a continuing interest
deduction is made in Gordon D. Dixon and Brian J. Arnold, “Rubbing Salt into the Wound:
The Denial of the Interest Deduction After the Loss of a Source of Income” (1991), vol.
39, no. 6 Canadian Tax Journal 1473-96.
33 For
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economically equivalent to interest but not within the legal definition.
Although these provisions address the deduction of many basic financing
charges, the statutory regime is far from comprehensive.
Under the restrictive concept of interest developed by the courts for
certain non-tax purposes,34 it is generally considered that an amount must
satisfy three conditions to be interest:
1) it must represent compensation for the use of borrowed money;
2) it must be referable to a principal sum; and
3) it must accrue on a daily basis.
Although there are some uncertainties regarding the precise meaning of
the second and third conditions, this legal definition of interest probably
includes only an amount that is calculated as a percentage of the principal
amount of a loan and is payable over the term of the loan for the use of
the borrowed funds.
There is some judicial authority supporting the adoption of the legal
definition of interest for income tax purposes. 35 On the basis of this judicial authority and the rather remote possibility of persuading the courts to
adopt a different definition of interest for tax purposes, Revenue Canada
has consistently applied the strict concept of interest in developing its
administrative positions regarding the characterization of amounts such
as participating debt payments and original issue discount (OID). 36 Consequently, many financing expenses have been excluded from the deduction
in paragraph 20(1)(c), even though, economically, these expenses represent the cost of borrowed funds. To ensure that a deduction is available,
the Department of Finance has responded by enacting specific provisions.
For example, as noted earlier, subsection 18(9.1) was added in 1991 to
permit the limited deduction of certain bonus, penalty, and rate reduction
payments as prepaid interest where the payments are made by borrowers
in the course of carrying on business. Similarly, subsection 16(6) and regulation 7001 treat amounts based on increases in the consumer price index
as interest payments made by a borrower. Other financing expenses that
represent costs incurred in acquiring borrowed funds, but are not necessarily compensation for the use of the funds, are generally deductible, in
34 See, for example, Reference Re Saskatchewan Farm Security Act, [1947] 3 DLR 689
(SCC); and AG Ont. v. Barfried Enterprises Ltd. (1963), 42 DLR (2d) 137 (SCC).
35 The clearest statement of this acceptance is found in Miller v. The Queen, 85 DTC
5354; [1985] 2 CTC 139 (FCTD).
36 See, for example, “Revenue Canada Round Table,” in Report of Proceedings of the
Fortieth Tax Conference, 1988 Conference Report (Toronto: Canadian Tax Foundation,
1989), 53:1-188, at 53:15 (characterization of original issue discount as interest); and
“Revenue Canada Panel,” in Creative Tax Planning for Real Estate Transactions—Beyond
Tax Reform and into the 1990s, 1989 Corporate Management Tax Conference (Toronto:
Canadian Tax Foundation, 1989), 8:1-59, at 8:9-11 (characterization of participating
payments).
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whole or in part, under paragraphs 20(1)(e), (e.1), and (e.2). Discounts
that are not interest are deductible, in part, under paragraph 20(1)(f ).
The legislative approach to the concept of interest for deductibility
purposes has been based, therefore, on the premise that the restrictive
legal definition of interest necessitates the enactment of specific provisions to ensure the deductibility of financing charges other than interest.
The alternative approach, which has been rejected by the Department of
Finance, is a comprehensive statutory definition of interest that would
include a broad range of financing charges that are economically equivalent to interest and should be deductible under a general rule applicable
to all expenses representing the cost of borrowed funds.
Use Test
Under an ideal income tax system, it is necessary to distinguish between
expenses incurred to earn income, which are deductible, and expenses
incurred for personal consumption, which are not deductible. This distinction, which applies to all expenses, including interest, is evident in
the basic test for the deduction of interest under paragraph 20(1)(c). Borrowed money (or property in the case of interest on the unpaid purchase
price of property) must be used for the purpose of earning income from a
business or property. It is not necessary that income be in fact earned, but
only that the funds be used for an income-earning or “eligible” purpose.
This purpose test is a common feature of deductions for tax purposes37
because it is necessary to permit deductions where the taxpayer’s business or investment property actually results in a loss.
The task of developing an appropriate approach to the determination of
the use of borrowed funds has been left to the courts. In general, the case
law has established that a taxpayer must trace borrowed funds to an eligible use in order to deduct interest.38 According to the Supreme Court in
Bronfman Trust, this tracing approach means that borrowed funds must be
used directly for an income-earning purpose, subject perhaps to some
limited exceptions discussed below. Moreover, the current or continuing
use of the borrowed funds, rather than the original use, determines whether
or not the interest is deductible.39 For example, interest on funds borrowed for an eligible purpose (say, the acquisition of a rental property)
ceases to be deductible if the funds are later used for an ineligible purpose (say, the rental property is converted to a personal residence or is
sold and the proceeds are used for personal consumption).
Although the tracing approach is well established, its precise meaning
has not been discussed extensively and it is not very well understood. It
is important to understand that, as applied by the courts, tracing does not
37 Paragraph
18(1)(a).
proposition was affirmed clearly by the Supreme Court of Canada in Bronfman
Trust, supra footnote 2.
39 Ibid.
38 This
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involve the patently foolish task of following the use of particular pieces
of currency. Money is simply a medium of exchange. The crucial point is
what goods or services are acquired with the money. Under a tracing
approach, the actual use of borrowed money is determined on the basis of
all the facts and circumstances that indicate a link between the borrowed
money and the acquisition of particular services or property. If the property or services are used for a qualifying purpose (that is, to earn income),
the interest is deductible; otherwise, it is not.
In our opinion, the cases clearly mandate direct use tracing in characterizing the purpose of a borrowing for purposes of the deduction of
interest. However, Revenue Canada, the courts, and Parliament have recognized exceptions to this tracing approach in limited circumstances.
Revenue Canada has recognized that it sometimes may be difficult, or
indeed impossible, to trace the use of funds. For example, borrowed funds
may be commingled with other funds in a business, so that the actual use
of the borrowed funds cannot be accurately determined. Generally, Revenue Canada takes the position in these circumstances that the funds have
been used to earn income from the business, particularly where there are
sufficient business assets to support the amount of the borrowing.40 Another instance in which tracing is impossible involves the sale by a taxpayer
of a portion of an asset that was originally acquired with borrowed funds
and has appreciated in value. In this case, it is impossible to determine,
using a tracing approach, whether the proceeds from a disposition of part
of the asset represent its cost (and thus the borrowed funds) or the increase
in its value (and thus the equity portion of the investment). The determination is important for the continued deduction of interest on the borrowed
funds, which depends on their continuing use. Revenue Canada takes the
position that the proceeds must be allocated on a pro rata basis between
the cost of the asset and the appreciation in value in determining the continuing use of the borrowed funds originally used to acquire the asset.41
In addition to these administrative exceptions where tracing is impossible, there are several judicial and statutory exceptions based on an
indirect use analysis. In these circumstances, it is possible to trace borrowed funds, but the direct use, in a strict sense, is not an eligible
income-earning use. In a broad sense, however, the funds can be said to
be used indirectly for an eligible purpose. For example, under subsection
20(3), borrowed money used to repay a debt is deemed to have been used
for the same purpose as the previously borrowed funds. Similarly, in
Trans-Prairie Pipelines Ltd. v. MNR, 42 the Exchequer Court held that in-
40 See, for example, Robert Couzin, James R. Daman, Michael Hiltz, and William R.
Lawlor, “Tax Treatment of Interest: Bronfman Trust and the June 2, 1987 Release,” in
Current Developments in Measuring Business Income for Tax Purposes, 1987 Corporate
Management Tax Conference (Toronto: Canadian Tax Foundation, 1987), 10:1-25, question 33, at 10:25.
41 Ibid., question 22, at 10:20-21.
42 70 DTC 6351; [1970] CTC 537 (Ex. Ct.).
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DEDUCTIBILITY OF INTEREST EXPENSE
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terest on borrowed money used to redeem preferred shares was deductible. In both instances, the direct use of the borrowed funds (repayment
of a debt obligation or the redemption of shares) does not produce income
and is technically ineligible. Nevertheless, if the funds effectively replace
capital that was used to earn income, the refinancing can be considered to
be an eligible use in an indirect sense. Not surprisingly, Revenue Canada
accepted the result in the Trans-Prairie case and issued Interpretation
Bulletin IT-80 in 1972,43 indicating that it would allow the deductibility
of interest on borrowed money used to redeem shares or pay dividends to
the extent that a corporation had accumulated profits. Over the years,
Revenue Canada issued other interpretation bulletins allowing the
deductibility of interest in certain other situations on the basis of the
indirect use approach.44
The status of all of these judicial and administrative exceptions based
on an indirect use analysis became doubtful following the decision of the
Supreme Court of Canada in Bronfman Trust in 1987. In that case, the
court held that interest on borrowed money used by a trust to make a distribution to a beneficiary was not deductible because the money was not
used directly for an income-earning purpose. An indirect use approach (the
preservation of the income-earning assets of the trust) was rejected. The
court did not, however, expressly overrule the Trans-Prairie case, and even
alluded to the possibility that there might be “exceptional circumstances
in which, on a real appreciation of a taxpayer’s transactions, it might be
appropriate to allow the taxpayer to deduct interest on funds borrowed for
an ineligible use because of an indirect effect on the taxpayer’s incomeearning capacity.”45 Nevertheless, Revenue Canada interpreted the decision
as effectively overruling the Trans-Prairie case. 46 As a result, on February 12, 1987, Revenue Canada cancelled IT -80. It is understood that
43 Interpretation Bulletin IT-80, “Interest on Money Borrowed To Redeem Shares, or
To Pay Dividends,” November 27, 1972.
44 See Interpretation Bulletin IT-445, “The Deduction of Interest on Borrowed Funds
Either To Be Loaned at Less than a Reasonable Rate of Interest or To Honour a Guarantee
Given for Inadequate Consideration in Non-Arm’s Length Circumstances,” February 23,
1981; and Interpretation Bulletin IT-498, “The Deductibility of Interest on Money Borrowed To Reloan to Employees or Shareholders,” October 6, 1983.
45 Bronfman Trust, supra footnote 2, at 5067; 129.
46 See, however, Grenier v. MNR, 92 DTC 1678; [1992] 1 CTC 2703, where the Tax
Court of Canada held that interest was deductible on the basis of the Trans-Prairie case,
which was not overruled by the decision in Bronfman Trust. The result in Grenier should
be compared with that in Livingston International Inc. v. The Queen, 91 DTC 5066; [1991]
1 CTC 155 (FCTD); aff ’d. 92 DTC 6197; [1992] 1 CTC 217 (FCA). In Livingston International, the taxpayer used $6 million of borrowed money to redeem outstanding preferred
shares; the court held that interest on the money was not deductible to the extent that the
borrowing exceeded the corporation’s retained earnings and paid-up capital on hand immediately before the redemption. Pinard J of the Federal Court—Trial Division, supra, at
5069-70; 160, suggested that “[i]n light of the Bronfman Trust decision, it would seem to
me that one cannot infer from the Trans-Prairie case that interest on borrowed money used
to redeem shares is generally deductible.”
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Revenue Canada was also considering the cancellation of its other interpretation bulletins based on the indirect use of borrowed money. This
disavowal of the department’s administrative positions based on the indirect use approach caused considerable controversy in the tax community.
In order to alleviate the uncertainty and preserve Revenue Canada’s
existing administrative practices, the Department of Finance introduced a
notice of ways and means motion on June 2, 1987.47 After extending the
notice three times, the minister of finance released draft legislation on
December 20, 1991. 48 The draft legislation, which after almost four years
has still not been enacted, authorizes the deduction of interest in the four
circumstances dealt with in the notice of ways and means motion originally introduced on June 2, 1987:
1) interest on borrowed money used to make certain interest-free loans
under section 80.4;
2) interest on borrowed money used to acquire fixed-dividend shares;
3) interest on borrowed funds provided by a shareholder to a corporation or a partner to a partnership; and
4) interest on borrowed money used by a corporation or partnership to
make a distribution.
The most important and contentious aspect of the draft legislation is
the deduction of interest on borrowed money used to make a distribution.
In principle, the draft legislation is intended to continue Revenue Canada’s administrative practice as it existed before Bronfman Trust (subject
to a few modifications). The legislation is extremely complex, and the
government has acknowledged that it contains several flaws that require
correction before enactment. Perhaps most important, the draft legislation
indicates that the government has rejected the deductibility of interest
based exclusively on direct use tracing as espoused by the Supreme Court
in Bronfman Trust. Direct use tracing will be retained as the basic test,
but specific exceptions will be provided for those situations that were
recognized as exceptions by Revenue Canada on an administrative basis
before Bronfman Trust. It appears, however, that the government is not
prepared to recognize any other exceptions at this time.
It is fair to question the need for the draft legislation. For the most
part, the legislation will simply restore the status quo as it existed before
the Supreme Court’s decision in Bronfman Trust while clarifying some
aspects of Revenue Canada’s longstanding administrative practices. For
example, the concept of accumulated profits will be replaced by a detailed definition of “tax equity” as the limitation on the amount of borrowed
funds that can be used to make a distribution. Even so, we doubt that the
legislation would have been necessary in the absence of the Bronfman
Trust decision. Taxpayers, Revenue Canada, and the Department of Finance
47 Supra
48 Supra
footnote 28.
footnote 4.
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were all reasonably content with the pre-Bronfman Trust situation. Revenue Canada’s administrative practices worked reasonably well and
continue to do so. The government appears content to shelve the draft
legislation indefinitely. Although this result makes good practical sense,
it ignores the Bronfman Trust case. If the Bronfman Trust case can be
ignored today, why were the notice of ways and means motion and the
draft legislation necessary at all?
Timing
The appropriate rules for the timing of the deduction of interest expense
have not received the same attention from the courts, policy makers, or
commentators as have the definitional and indirect use problems. To the
extent that the timing question has been considered, the focus has been on
two primary issues:
1) deductibility on a cash basis; and
2) the appropriateness of deductibility on a payable or accrual basis
for taxpayers unable to use the cash basis.
In theory, interest may be deducted in the year in which it is paid (“the
cash method”), in the year in which it is incurred or becomes payable
(“the payable method”), or in the year in which it accrues (“the accrual
method”). The concept of payment is self-explanatory and well understood. There is, however, some confusion about the difference between
the payable and accrual methods. An amount becomes payable when a
taxpayer has an unconditional legal liability to pay the amount, notwithstanding that the time for payment may be some time in the future; thus,
an amount may be payable or an expense may be incurred even though
the taxpayer is not obliged to pay until a subsequent year. Certain amounts,
including interest, may accrue on a daily basis, even though they have not
become payable. The confusion between the payable and accrual methods
arises because there is a temporal aspect to the liability to pay interest. In
short, interest can be calculated precisely at any time as it accrues, even
though it is not payable. For example, the obligation to pay interest may
be conditional on the occurrence of some event, such as the use of the
relevant funds by a borrower for the full term of a loan. Once the event
occurs, the payments may be considered interest determined retroactively
for the use of borrowed funds in previous years. Deductibility on a payable basis means that all interest for all periods is deductible in the year
in which the contingency is satisfied. In contrast, deductibility on an
accrual basis means that the interest is apportioned and deductible over
all of the periods on a daily basis.
The timing of the deduction of interest expense is specifically governed by paragraph 20(1)(c), which permits the deduction of interest “paid
in a taxation year or payable in respect of the year . . . (depending on the
method regularly followed by the taxpayer in computing his income).”
This wording, which was adopted in 1948, expressly recognizes both the
cash and payable methods for the deduction of interest expense. What
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was not clear until the decisions in The Queen v. Terra Mining & Exploration Limited ( NPL)49 and MNR v. Mid-West Abrasive Co. of Canada
Ltd. 50 was which taxpayers may use the cash basis, and whether the words
“in respect of ” require interest expense to be allocated to taxation years
on an accrual basis for deduction purposes.
A literal reading of the wording of paragraph 20(1)(c) appears to provide a taxpayer with the option of recognizing interest expense on a cash
or payable basis for each source of income, provided that the taxpayer
regularly follows the particular method. This interpretation has been
adopted in connection with the recognition of interest income under paragraph 12(1)(c), which contains similar wording;51 however, in that context,
the apparent flexibility of the statute has been minimized by the enactment of other provisions that require the recognition of interest income
on an accrual basis. Similarly, any apparent flexibility in the timing of the
deduction of interest under paragraph 20(1)(c) has been minimized by the
decision in the Terra Mining case, which effectively limits the use of the
cash method to taxpayers who use that method generally in calculating
income from the related source. In other words, a taxpayer who computes
income from a particular source for tax purposes on an accrual basis
cannot deduct interest expense under paragraph 20(1)(c) on a cash basis.52
The deduction of compound interest under paragraph 20(1)(d) on a
cash basis remains a curious anomaly. Taxpayers who recognize revenue
and expenses on an accrual basis generally should not be able to deduct
compound interest on a cash basis. Compound interest is indistinguishable from simple interest with respect to the timing of the deduction. The
problem of the deductibility of compound interest on a cash basis has
been highlighted by OID that is characterized as interest. Revenue Canada
has consistently taken the technically correct position that the compound
interest element in OID can be deducted by a borrower only on a cash
basis and not as it accrues.53 However, the enactment of subsection 18(9.2),
described earlier, has unintentionally permitted borrowers to issue the
equivalent of OID obligations and deduct the compound interest element
on an accrual basis simply by issuing a debt obligation with a stated
49 84
DTC 6185; [1984] CTC 176 (FCTD).
DTC 5429; [1973] CTC 548 (FCTD).
51 See Interpretation Bulletin IT-396R, “Interest Income,” May 29, 1984, paragraphs 6
and 7; and Industrial Mortgage and Trust Co. v. MNR, 58 DTC 1060; [1958] CTC 106
(Ex. Ct.).
52 A taxpayer who recognizes income, such as dividends, on a cash basis may be able
to deduct interest on an accrual basis provided that this method is followed regularly. See
Plawiuk v. The Queen, 94 DTC 1050; [1994] 1 CTC 2077 (TCC).
53 See, for example, the technical interpretation of the Financial Industries Division, in
Revenue Canada Views [database online], document no. 9421957, September 9, 1994; and
John A. Calderwood, “A Revenue Canada Perspective on Offshore Funds, Commodity
Straddles, and Offshore Deep Discount Bonds and Treasury Bills,” in Report of Proceedings of the Thirty-Fifth Tax Conference, 1983 Conference Report (Toronto: Canadian Tax
Foundation, 1984), 253-64, at 262.
50 73
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interest rate and prepaying the interest.54 This strange result emphasizes
the need for the timing rules for compound interest to be amended to
conform with those for simple interest.
For taxpayers who are unable to use the cash method, the timing of the
deduction of interest expense under paragraph 20(1)(c) is unclear because
of the words “in respect of the year.” If the phrase is considered to
modify the word “amount,” interest expense appears to be deductible in
the year in which the borrowed money or property is used. If the phrase is
considered to modify the word “payable,” the interest deduction must be
claimed in the year in which the expense becomes payable, regardless of
the time at which it accrued. In the Mid-West Abrasive case, the Federal
Court—Trial Division held that interest was deductible in the year in
which the borrowed money was used with the additional requirement that
the expense must also be payable. In other words, interest must be allocated on an accrual basis to the year in which borrowed money was used,
but only after it becomes payable.55
In some instances, the application of this timing principle can effectively deny the deduction of otherwise deductible interest expense. Such
a result can occur where interest becomes payable in a taxation year
following the year in which the expense accrued. In that case, the interest
is not deductible in the year in which the expense becomes payable because it does not accrue for that year and therefore is not payable in
respect of that year. On the other hand, the interest could not have been
deducted in the year in which it accrued because it was not payable in
that year. A taxpayer may be prohibited from reopening the previous year
and claiming a deduction for the accrued interest that subsequently became payable. It is our understanding, however, that Revenue Canada
generally permits accrual-basis taxpayers to deduct interest in the year in
which the expense accrues. This practical approach is an obvious and
straightforward solution to the potential timing problem created by the
Mid-West Abrasive case. The Department of Finance should amend paragraph 20(1)(c) to accord with Revenue Canada’s administrative practice
and require the deduction of interest expense as it accrues, unless income
from the relevant source is recognized on a cash basis.
MAJOR POLICY ISSUES
In this section of the article, we review six of the more important policy
issues concerning the deduction of interest. The first involves a significant change to the statutory basis for the deduction of interest under the
Act. The second, third, fourth, and fifth issues are all related to the
54 See Stephen R. Richardson, “New Financial Instruments: A Canadian Tax Perspective,” in Income Tax and Goods and Services Tax Considerations in Corporate Financing,
1992 Corporate Management Tax Conference (Toronto: Canadian Tax Foundation, 1993),
10:1-32, at 10:25-27 and 10:31-32.
55 See also Fernwood Construction of Canada Ltd. v. MNR, 85 DTC 257; [1985] 1 CTC
2289 (TCC); and Hassan v. MNR, 62 DTC 451; (1962), 30 Tax ABC 48.
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definitional, use test, and timing aspects of the deduction of interest described above. The last area concerns the general problem of the
deductibility of interest expense incurred to earn preferentially taxed income and, in particular, the deduction of interest incurred to earn
investment and foreign source income.
Deduction of Interest Under Section 9
As already noted, the existence of a specific statutory provision permitting the deduction of interest is based on the premise that interest would
otherwise be considered a non-deductible capital expense. This general
proposition is subject to a possible exception for financial institutions
and other moneylenders who may be able to deduct interest and other
financing expenses under section 9 as current costs incurred in acquiring
money, which is their inventory.56 For all other taxpayers, the characterization of interest as a capital expense means that the conditions in
paragraph 20(1)(c) must be satisfied for interest to be deductible. In contrast, other business expenses are deductible under section 9 in accordance
with ordinary commercial accounting practices subject to any overriding
case law principles and statutory provisions.
In our view, the characterization of interest as a capital expense is
based on a misreading of early UK and Canadian cases.57 Even so, as
recently as the decision in Bronfman Trust, the Supreme Court has clearly
stated its acceptance of this characterization. Consequently, the deduction
of interest expense by all taxpayers under section 9 probably requires the
enactment of an express statutory provision overturning the conventional
characterization as a capital expense, namely, a specific exclusion from
the prohibition on the deduction of capital expenses in paragraph 18(1)(b).
This alternative was recommended by the Joint Committee on Taxation of
the Canadian Bar Association and the Canadian Institute of Chartered
Accountants in a 1990 submission to the minister of finance on the deduction of interest.58 If paragraph 20(1)(c), and the related provisions in
subsection 18(9.1) and paragraphs 20(1)(d), (e), (e.1), and (f ), were repealed, interest and other financing expenses would be deductible under
section 9 if they were incurred for an income-earning purpose and were
deductible in accordance with accounting principles. As a result, it would
no longer be necessary to meet the additional requirements of paragraph
20(1)(c) (borrowed money, legal obligation to pay interest, etc.) and the
56 See Tim Edgar, “Deduction of Loan Losses and Financing Expenses by Moneylenders,” in Report of Proceedings of the Forty-Sixth Tax Conference, 1994 Conference Report
(Toronto: Canadian Tax Foundation, 1995), 16:1-52.
57 See Arnold, supra footnote 9. See also Howard J. Kellough, “Emerging Income Tax
Issues: Section 231.2 Requirement Letters, Uses and Abuses of Trusts, and Interest
Deductibility,” in the 1993 Conference Report, supra footnote 33, 2:1-36, at 2:31-33.
58 Joint Committee on Taxation of the Canadian Bar Association and the Canadian
Institute of Chartered Accountants, “Submission to the Minister of Finance on the Issue of
the Deductibility of Interest,” in Canadian Tax Reports, Special Report no. 964, extra ed.
(Don Mills, Ont.: CCH Canadian, August 1990).
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other provisions. However, the deduction of interest and other financing
expenses would presumably continue to be subject to the prohibitions in
paragraphs 18(1)(a), (c), and (e), the reasonableness requirement in section 67, and other provisions, such as the thin capitalization rules and any
capitalization requirements.
Although the proposal is intriguing, its attractiveness may be more
apparent than real. In fact, the deduction of interest under section 9 raises
many of the same definitional, tracing, and timing issues that are currently encountered under paragraph 20(1)(c). For example, it would still
be necessary to distinguish between debt and equity because the treatment of interest and dividends would continue to be different. This issue
is most problematic with sophisticated financial instruments in respect of
which the basic distinction between debt and equity is sometimes blurred.
It is also unclear whether the courts would use the same tracing approach
under section 9 that is used under paragraph 20(1)(c). With respect to the
timing of the interest deduction, a choice would have to be made between
the payable basis preferred in the case law for business expenses generally and the accrual basis used for interest expense for accounting purposes.
Although it seems likely that these basic issues would be dealt with
under section 9 in the same way as they are currently dealt with under
paragraph 20(1)(c), the issues should be carefully studied. In particular, it
should be remembered that many aspects of the basic definitional, tracing, and timing issues are fairly well settled under specific provisions of
the Act. Moreover, the deduction for interest and other basic financing
charges has been consistently liberalized over the years through statutory
amendments. Consequently, it may be more efficient to maintain the current statutory regime and address technical anomalies as they arise through
continued amendments or administrative practices. The larger issues, such
as the appropriate treatment of financial products, probably must be dealt
with, if at all, through specific legislation, even if interest is deductible
under section 9.
Statutory Definition of Interest
For deductibility purposes, the principal definitional problem under the
Act arises in connection with the proper treatment of financing expenses
associated with sophisticated financial products, including derivative instruments, hedging arrangements, and foreign exchange gains and losses.
Arguably, the current deductions and Revenue Canada’s administrative
practices adequately address the deduction of basic financing expenses,
such as discounts, bonuses, rate reduction payments, and participating
payments. In contrast, the treatment of more sophisticated financing arrangements and the distinction between debt and equity securities remains
unclear. This uncertainty raises the question whether a comprehensive
statutory definition of interest is necessary.
There are three possible approaches to the definitional issues raised by
the treatment of financial products. First, under the current rules, taxpayers and Revenue Canada are left to struggle with the application of the
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legal definition of interest to sophisticated financial products and hedging
arrangements. This approach is unsatisfactory because expenses that economically represent costs of borrowing, but are not specifically recognized
as such in the Act, are not deductible either under paragraph 20(1)(c) as
interest or under any of the other specific provisions for the deduction of
financing expenses. Moreover, the uncertainty of the current approach
discourages taxpayers from using certain financial products that may be
commercially advantageous.
The second approach involves the enactment of specific rules for specific financial products on an ad hoc basis. In effect, specific rules would
be necessary for sophisticated financial products and hedging arrangements, just as specific rules have been adopted for financing expenses
other than interest. Although this approach has been successful for financing expenses other than interest, it is less likely to be appropriate
when applied to the infinite variety of more sophisticated arrangements
that are continually being developed by the market.
The third approach involves the enactment of a comprehensive statutory definition of interest that includes all amounts representing the cost
of borrowed funds and foreign exchange gains and losses that are functionally equivalent to interest. Theoretically, this kind of comprehensive
approach to the definition of interest and the deductibility of financing
charges is preferable because it results in the similar treatment of economically similar amounts that represent compensation for the use of
borrowed funds. To some extent, this theoretical attractiveness is diminished by the enormous administrative and compliance difficulties that
inevitably result from a comprehensive approach. These difficulties are
readily apparent in the New Zealand accrual rules,59 which require the
accrual recognition by debtors and creditors of the annual return on “financial arrangements.”60 Nonetheless, the lack of any statutory guidance
under the current approach creates similar administrative and compliance
costs because the current statutory provisions are not readily applicable
to financial arrangements that are far more sophisticated than the conventional financing techniques contemplated by the provisions. The need for
appropriate statutory provisions to govern the tax treatment of sophisticated financial products is likely to become increasingly apparent.
The Department of Finance appears to have rejected a comprehensive
statutory definition of interest in favour of limited responses to specific
problems. Recent examples are the enactment of subsection 18(9.2) dealing with long-term prepaid debt obligations and the mark-to-market
legislation dealing with the recognition of income on certain shares and
59 See generally, Susan Glazebrook and Robin Oliver, The New Zealand Accrual Regime—A Practical Guide (Auckland, NZ: CCH, 1989).
60 A “financial arrangement” is defined broadly to include (1) any debt obligation,
(2) any arrangement whereby a person obtains money in consideration for a promise to
pay at some future time, and (3) any arrangement of a substantially similar nature. New
Zealand Income Tax Act 1976, as amended, section 64B.
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debt obligations held by financial institutions. Consistent with this approach, some consideration might be given to rationalizing the definitional
problems in a limited way. One obvious initiative is to make the present
rules in subsection 12(9) and regulation 7000, which require the recognition of income from certain financial instruments on an annual accrual
basis, applicable to issuers. The lack of symmetrical treatment for issuers
of these products is a curious feature of the Canadian tax system that no
longer seems justified, at least with respect to resident holders. With
non-resident holders, who must remain subject to withholding tax on a
cash basis, a serious mismatching of revenue and expenses could occur if
a resident borrower were permitted to deduct the relevant expense on an
accrual basis.
Even comprehensive rules providing for the deduction of all financing
charges that represent the cost of borrowed funds must distinguish between
debt and equity. Unlike interest, dividends are not deductible by the payer.
The distinction is particularly problematic with respect to hybrid securities, which have a risk and return mix that combines elements of both debt
and equity. Under current rules, however, such hybrid securities must be
classified as one or the other for tax purposes. The difficulties in making
this distinction provide the basic conceptual background to the after-tax
financing problem and the present preferred share rules;61 they also form
the conceptual framework underlying the problem of thin capitalization.
Thin Capitalization
The thin capitalization issue arises from the different tax treatment of
interest and dividends derived by non-resident investors. In general, interest on debt issued by a Canadian corporation is deductible by the payer
and subject to Canadian withholding tax when paid to a non-resident. On
the other hand, dividends are not deductible but are subject to Canadian
withholding tax when paid to a non-resident shareholder, without any
credit for corporate tax on the underlying profits. The different treatment
of dividends and interest provides an obvious incentive for non-residents
to repatriate corporate profits earned in Canada in the form of interest.
Since tax reform in 1972, this problem has been addressed by denying a
Canadian corporation a deduction for interest expense payable to certain
non-residents in respect of debt in excess of three times the corporation’s
equity. 62 In effect, such debt is considered to be “disguised” equity.
The thin capitalization rules are technically deficient in several respects. Moreover, Canada’s status as a relatively high-tax jurisdiction
places pressure on the thin capitalization rules because foreign multinationals have an added incentive to finance their Canadian subsidiaries
with debt in order to maximize the tax saving from the interest deduction.
61 See Tim Edgar, “The Classification of Corporate Securities for Income Tax Purposes” (1990), vol. 38, no. 5 Canadian Tax Journal 1141-88.
62 Subsections 18(4) to (6).
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The thin capitalization rules should be strengthened. The recent US and
Australian thin capitalization provisions, which are somewhat similar to
the Canadian rules in their general design, could serve as useful models.63
Alternatives to Tracing
Any alternative to the tracing approach adopted by Canadian courts in
applying the use test under paragraph 20(1)(c) involves the allocation of
interest between eligible and ineligible uses on the basis of some assumption concerning the use of borrowed funds, rather than their actual use.
Some commentators refer to these other approaches as fungibility. However, fungibility is an inappropriate term, since it suggests that under
tracing the fungibility of money is ignored or rejected. Although, as a
matter of fact, money is generally fungible, this fact does not assist the
determination whether interest on borrowed money is attributable to an
eligible or an ineligible use.
The alternatives to tracing can be divided into two major categories:
apportionment and ordering rules. Under an apportionment approach, borrowed funds might be allocated between personal and income-earning
assets on a pro rata basis in accordance with the book value, the tax cost,
or the fair market value of those assets. Alternatively, under ordering
rules, borrowed funds might be allocated first to income-producing assets
to the maximum extent possible and then, in the event of any excess, to
personal assets (positive ordering), or vice versa (negative ordering). The
former approach is generous to taxpayers; it is equivalent to the most
advantageous ordering of transactions under a tracing approach. Under
any of these approaches, the actual ordering of transactions is irrelevant.
The tracing of borrowed money to a particular use means only that other
funds have become available for other uses.
The debate concerning the desirability of tracing as compared with
these other approaches has raged vigorously for several years.64 Critics of
tracing argue that it is artificial, puts an inappropriate premium on tax
planning, and is difficult to administer. They argue that, because money
is fungible, borrowers are economically indifferent about whether debt or
equity is used to acquire particular assets. Proponents of tracing, on the
63 See the US Internal Revenue Code of 1986, as amended, section 163(j) and the
Australian Income Tax Assessment Act 1936, as amended, division 16F. Possible reforms
of the Canadian rules are discussed in Tim Edgar, “The Thin Capitalization Rules: Role
and Reform” (1992), vol. 40, no. 1 Canadian Tax Journal 1-54.
64 See, for example, Gordon Bale, “The Interest Deduction Dilemma” (1973), vol. 21,
no. 4 Canadian Tax Journal 317-36; Alan Gunn, “The Interest Deduction” (Winter 1979),
1 Canadian Taxation 46-50; William A. Klein, “Borrowing To Finance Tax-Favored Investments” [1962], no. 4 Wisconsin Law Review 608-36; Michael J. McIntyre, “Tracing
Rules and the Deduction for Interest Payments: A Justification for Tracing and a Critique
of Recent US Tracing Rules” (Fall 1992), 39 The Wayne Law Review 67-120, at 69-85;
Michael J. McIntyre, “An Inquiry into the Special Status of Interest Payments” [1981], no.
5 Duke Law Journal 765-810; and “The Deductibility of Interest Costs by a Taxpayer
Holding Tax Exempt Obligations: A Neutral Principle of Allocation,” Notes feature (February 1975), 61 Virginia Law Review 211-35.
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other hand, argue that the ordering of transactions is not irrelevant and
that the valuation problems associated with apportionment and ordering
rules cause enormous compliance problems. In our view, this debate can
never be resolved satisfactorily on a theoretical basis. Tracing and other
approaches are second-best solutions with serious deficiencies. As long
as some forms of income (especially imputed income from owned assets)
are not taxable, interest on borrowed funds used to acquire such assets
should not be deductible. Consequently, some rule is necessary to determine whether, or to what extent, interest is attributable to non-taxable
income or personal consumption.
As a practical matter, tracing is familiar, although flawed. It is theoretically deficient because it results in economically similar situations
being treated differently. However, tracing is well known to taxpayers, as
well as tax advisers; consequently, much of the unfairness resulting from
the application of a tracing rule can be avoided through elementary planning. For instance, it is widely appreciated by individuals that savings
should be used for personal consumption and debt should be used for
income-producing purposes. Similarly, corporations have often engaged
in the practice of “cash-damming” techniques to ensure that borrowed
funds can be traced to an eligible use. Therefore, in the final analysis, the
familiarity of tracing makes it preferable to any other approach. For this
reason, the basic tracing approach currently used to determine interest
deductibility should be retained. There is little to be gained from switching to some type of apportionment or ordering rule.
Comprehensive Capitalization Rules
It is generally accepted that, under a comprehensive income tax, capital
costs should not be deducted in full in the year in which they are incurred
but should be allocated in a systematic manner to future taxation years
and deducted in those years as revenue is recognized from the use of
capital assets. Although vigorously contested by some commentators,65
this fundamental principle of income measurement means that interest
expense should not always be deductible as a current expense; sometimes
it should be deductible currently and sometimes it should be capitalized
and deducted in future taxation years, depending on the use of the borrowed funds.66 For example, where borrowed funds are used to finance
current expenditures of a business, such as the payment of salaries, the
interest should be deductible currently. In contrast, where borrowed money
is used to acquire inventory or non-depreciable capital property that does
not produce a current return (for example, vacant land, gold, and works
65 See, for example, Robert Couzin, “Discussant’s Remarks,” in Roy D. Hogg and Jack
M. Mintz, eds., Tax Effects on the Financing of Medium and Small Public Corporations
(Kingston, Ont.: John Deutsch Institute for the Study of Economic Policy, 1992), 79-84;
and Robert Couzin, Brian J. Ernewein, and William R. Lawlor, “Interest Expense: The
December 20, 1991 Draft Amendments,” in the 1992 Corporate Management Tax Conference, supra footnote 54, 2:1-42, at 2:8-9.
66 See McIntyre, supra footnote 64.
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of art), the interest should be added to the cost of the property and deducted only when a gain or loss is realized on a disposition. This treatment
is inappropriate with respect to depreciable capital property and
non-depreciable capital property that produces current income. In theory,
some portion of any related interest expense should be allocated to the
current return and deducted currently, while the balance of the expense
should be capitalized. Practical difficulties in implementing this approach
may mean that interest expense on borrowed funds used to acquire these
assets should be either deductible currently or capitalized in full.
Despite the importance of the question, the need for comprehensive
capitalization rules has received little attention in Canada and most other
countries. The capitalization of interest expense under the Act is imposed
in a rather confusing, inconsistent manner that differs from the theoretical
ideal. Moreover, the treatment for income tax purposes differs in many
respects from the treatment for financial accounting purposes. Under generally accepted accounting principles, interest expense is normally
recognized as it accrues and is shown as an expense separate from the
operating expenses of a business.
As already described, Canadian income tax legislation has, since 1923,
specifically provided a current deduction for interest expense incurred to
earn income. This general rule is subject to various provisions requiring
the deferred recognition of prepaid interest.67 The Act also contains several provisions that effectively require or permit interest expense to be
capitalized, namely, the following:
• Under section 21, a taxpayer may elect to add interest and other
financing expenses in respect of borrowed money used to acquire
depreciable property or to incur Canadian or foreign resource expenses to
the cost of the depreciable property or to the relevant resource account. If
an election is made, the interest is not currently deductible but is deductible over time in accordance with the statutory rules for capital cost
allowance and resource deductions. In effect, taxpayers are given the
option of treating the interest as a current expense or as a cost of acquiring depreciable or resource property.
• Under subsection 18(2), interest on borrowed money used to acquire
certain vacant land (or interest in respect of the unpaid purchase price of
certain vacant land) is deductible in any year only to the extent of the net
income from the land. Any interest that is not deductible under subsection
18(2) is added to the adjusted cost base or cost of the land. This rule does
not apply to land used in a business (other than a business of selling or
developing land) or used primarily to earn income. In effect, subsection
18(2) requires interest in respect of the acquisition of vacant land to be
capitalized as part of the cost of the land. Consequently, the interest is
taken into account for income tax purposes only when the land is sold.
67 Subsections
18(9) and 18(9.2) to (9.8).
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• Under subsection 18(3.1), soft costs, including interest, relating to
the period during which a building is under construction, renovation, or
alteration are not currently deductible. Such costs must be added to the
cost of the land or building. Therefore, interest expense incurred as a
construction period soft cost is taken into account by way of capital cost
allowance if the interest relates to a building, or as part of the cost of the
land when it is sold if the interest relates to land.
Apart from these provisions, there is no requirement in the Act to
capitalize interest expense, nor has there ever been such a general requirement. It is also unlikely that the government will attempt to design
comprehensive capitalization rules in the near future. Nonetheless, even
accepting the limited scope of the current provisions, there are two obvious problems that could be addressed. Both of these problems concern
the deduction of interest on borrowed money used to acquire a nondepreciable capital asset.
The first problem arises from the current deduction of interest expense
on borrowed money used to acquire property (for example, common shares)
that produces both a current income stream (dividends) and capital appreciation. Since a capital gain is, by definition, not income from a business
or property, 68 interest incurred to earn a capital gain is not deductible
under paragraph 20(1)(c). 69 For assets that generate both current income
and capital gains, it is therefore important for interest expense to be
allocated between the two types of return. The Act, however, contains no
such allocation rules. Instead, there is administrative and judicial authority supporting the deduction of interest expense to the extent of the current
return on an investment asset, even where the return is fixed and less than
the amount of the expense.70 Moreover, Revenue Canada and the courts
ordinarily permit the current deduction of interest in full as long as there
is some possibility that the property will ultimately generate income in
excess of the interest expense.71 The revenue erosion that can result from
68 Subsection
9(3).
Ludmer et al. v. MNR, 93 DTC 1351; [1993] 2 CTC 2494 (TCC); aff ’d. 94 DTC
6221; [1994] 1 CTC 368 (FCTD) and 95 DTC 5311 (FCA), for an application of this
prohibition.
70 See, for example, “Revenue Canada Round Table,” in the 1993 Conference Report,
supra footnote 33, 58:1-76, question 8, at 58:5; “Revenue Canada Round Table,” in Report
of Proceedings of the Thirty-First Tax Conference, 1979 Conference Report (Toronto:
Canadian Tax Foundation, 1980), 601-38, question 3, at 606-8. See also Mark Resources
Inc. v. The Queen, 93 DTC 1004; [1993] 2 CTC 2258 (TCC).
71 This conclusion is most obvious with interest expense on borrowed money used to
acquire common shares with an unlimited right to participate in corporate profits. See, for
example, “Revenue Canada Round Table,” in the 1988 Conference Report, supra footnote
36, at 53:15; Couzin et al., supra footnote 40, question 24, at 10:21-22; “Revenue Canada
Round Table,” in Report of Proceedings of the Thirty-Third Tax Conference, 1981 Conference Report (Toronto: Canadian Tax Foundation, 1982), 726-66, question 39, at 754-56;
Haig v. MNR, 72 DTC 1465; [1972] CTC 2562 (TRB); and Lessard v. MNR, 93 DTC 680;
[1993] 1 CTC 2176 (TCC).
69 See
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the current deduction of interest expense related to the earning of investment income by individuals motivated the government’s restricted interest
proposal in the 1981 budget. The continuing need for such a restriction
and the relevant policy constraints are discussed below.
The second problem relates to the denial of any deduction for interest
on borrowed money used to earn capital gains. Such interest is not deductible currently and cannot be added to the cost of the particular
property.72 This position is based on a restrictive judicial interpretation of
the word “cost” for income tax purposes. 73 Under this interpretation, the
cost of property does not include any associated financing charges, including interest. The Act should be amended to allow such interest to be
added to the cost of capital property consistent with the theory underlying
the capitalization of interest expense.74
Restrictions on the Deduction of Interest
General Treatment of Interest Expense Incurred To Earn
Preferentially Taxed Income
The denial of the deduction of interest incurred for a purpose other than
the earning of business or property income is the most important restriction on the deduction of interest under paragraph 20(1)(c); it has meant
that interest incurred for personal consumption has not been deductible
since the introduction of the income tax in 1917. Canada has thereby
avoided the entrenchment of preferential tax laws, such as the deduction
of home mortgage interest, that have plagued the United States.
The Act also imposes some specific restrictions on the deduction of
interest, such as the thin capitalization rules and the capitalization requirements for interest related to the acquisition of vacant land or the
period of construction of a building. The tax policy justifications for
these restrictions have been discussed above. A more general problem
arises with the deduction of interest expense incurred to earn preferentially taxed income, particularly capital gains. The Act contains few
effective restrictions in this regard. The prohibition in paragraph 20(1)(c)
on the deduction of interest incurred for the purpose of earning exempt
income applies in limited circumstances because of the narrow definition
of exempt income. 75 The only specific restriction on the deduction of
interest incurred to earn preferentially taxed income is subsection 18(11),
which denies the deduction of interest on borrowed money used to make
contributions to tax-deferred retirement savings plans. As described earlier,
72 The interest may, of course, be deductible to the extent of any current return and
only the excess denied recognition. See supra footnote 70.
73 See, for example, The Queen v. Stirling, 85 DTC 5199; [1985] 1 CTC 275 (FCA).
74 This theory would presumably extend to interest on borrowed money used to acquire
(or the unpaid purchase price of ) personal-use property the gain on which is taxable.
Home mortgage interest would be excluded because of the exempt status of any realized
gains.
75 Subsection 248(1), the definition of “exempt income.”
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a capital gain or loss is excluded from the concept of property income for
the purpose of paragraph 20(1)(c). Therefore, interest incurred to earn a
capital gain or loss is not deductible. However, the courts and Revenue
Canada have taken a very generous approach in determining the purpose
of borrowed money used to acquire common shares that have the possibility of paying dividends.76 In short, the possibility that dividends will
be paid on shares has almost invariably been sufficient justification for
the full deduction of related interest expense.
If interest expense related to the earning of preferentially taxed income
is fully deductible, the borrower’s income is inaccurately measured in
two respects. First, the full deduction of interest expense in respect of
income that is taxed preferentially effectively reduces the tax payable on
other income. The full deduction of interest expense presupposes that the
related income is fully taxed. Second, if the income is fully taxed but is
not taxed currently, the full deduction of related interest expense on an
accrual or payable basis effectively results in a deferral of tax payable on
other income.
In theory, the problem of allowing a full current deduction for interest
expense incurred to earn income that is preferentially taxed (in the sense
either that the income is exempt from tax, in whole or in part, or that tax
on the income is deferred) is best solved by eliminating the preferential
treatment and taxing all income on a comprehensive and full accrual
basis. This approach has received considerable attention in the academic
literature, particularly in the United States. 77 However, it is so problematic (for example, it would require the annual valuation of all property)
that it has never been seriously considered. Therefore, by default, tax
policy analysis has focused on restrictions on the deduction of interest
expense as a second-best solution.
The two most important examples of the problem of allowing a full
current deduction for interest expense incurred to earn preferentially taxed
income are investment income earned by individuals and foreign source
income earned by resident taxpayers. Admittedly, these problems have
not been adequately addressed in most countries, including Canada. Even
so, some countries, notably the United States,78 have enacted substantial
restrictions to address the investment income problem. The foreign source
income problem has also received considerable attention in the light of
the auditor general’s 1992 report79 and the Tax Court of Canada decision
76 Supra
footnote 71.
for example, Mary Louise Fellows, “A Comprehensive Attack on Tax Deferral”
(February 1990), 88 Michigan Law Review 722-811; and David J. Shakow, “Taxation
Without Realization: A Proposal for Accrual Taxation” (June 1986), 134 University of
Pennsylvania Law Review 1111-1205.
78 See McIntyre, supra footnote 64.
79 Supra footnote 5.
77 See,
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in Mark Resources Inc. v. The Queen. 80 We conclude this article with a
discussion of these two problems.
Interest Expense Incurred To Earn Investment and
Foreign Source Income
In November 1981, the government proposed to restrict the deduction by
individuals of interest on borrowed money used to earn investment income. The reasons for the proposal were set out as follows:
The paper on tax expenditures reveals that many high-income individuals
who paid little or no tax in 1979 claimed deductions for interest expenses
that exceeded their investment income. The current tax law allows the full
deductibility of interest paid on funds borrowed to finance an investment
even if the income from the investment is deferred for tax purposes until
future years or is taxed at less than full rates. . . . The tax shelter created by
the current deductibility of all interest expense cannot be justified. As a
general principle of tax policy, interest expense should only be deductible
when the income to which it relates is taxed. To achieve this result, any
interest expense incurred to earn investment income will be deductible
only to the extent of such investment income, and any excess will have to
be carried forward for deduction against investment income in future years.81
This proposal was ultimately withdrawn as a result of a combination of
political opposition, technical difficulties, and its retroactive application.
Even though the tax policy premise underlying the proposal was sound
and remains sound, the only action that has been taken since November
1981 is the introduction of the cumulative net investment loss (CNIL)
account,82 which deals only with the most egregious mismatching of the
interest deduction and the taxation of investment income. In our view,
despite the bad press that the restricted interest expense proposal received
in 1981, the Department of Finance should reconsider the issue. The tax
policy justification for restrictions on the deductibility of interest by individuals earning investment income is overwhelming.83
As emphasized in the auditor general’s 1992 report, 84 the Canadian tax
system is also plagued by a serious structural deficiency involving the
deductibility of interest on funds borrowed to finance investments in foreign subsidiaries. If a Canadian corporation borrows funds that are used
to capitalize a foreign corporation, the interest is deductible in computing
the corporation’s income for Canadian tax purposes. However, the income derived by the foreign corporation is not subject to Canadian tax
until the Canadian corporation receives dividends from the foreign subsidiary. Moreover, if the foreign subsidiary is resident in certain listed
80 Supra
footnote 70.
Budget in More Detail, supra footnote 3, at 37.
82 Subsection 110.6(1).
83 D. Keith McNair, “Restricted Interest Expense” (1987), vol. 35, no. 3 Canadian Tax
Journal 616-49.
84 Supra footnote 5.
81 The
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countries, dividends received by the Canadian parent corporation out of
the subsidiary’s active business income may be exempt from Canadian
tax. 85 In addition, although certain dividends received by a Canadian corporation from a foreign subsidiary are not subject to any Canadian tax,
dividends paid by the Canadian corporation to individual shareholders
resident in Canada qualify for a dividend tax credit. This problem is
caused by the lack of any advance corporation tax and is not directly
attributable to the interest deduction.
In general, interest expense should be matched with a taxpayer’s investment or foreign source income and deducted only to the extent that
the revenue is realized in any taxation year. With respect to the investment income of individuals, the US passive loss rules and the CNIL account
could provide useful starting points for the design of a fair, effective, and
workable restricted interest expense rule. With foreign source income, it
is not enough, however, just to provide that interest expense matched
with such income can be deducted only to the extent that the income is
realized in a taxation year. Some method of allocating interest expense to
foreign source income, other than tracing, must be imposed, since tracing
(the current approach) provides taxpayers with undue flexibility in ordering their affairs. 86 In effect, under a tracing approach, a taxpayer can
allocate interest expense to domestic sources of income to the greatest
extent possible.
The alternative to tracing, some form of apportionment or ordering
rule, does not fit neatly with a direct use tracing approach to the allocation of interest expense between income-earning and non-income-earning
uses. More important, there are a number of difficult design issues that
must be addressed if an apportionment or ordering approach is adopted.
These issues have been described elsewhere.87 It is worth noting here that
the US Treasury department has provided a useful legislative model for
the apportionment of interest expense between foreign and domestic
sources of income.88 The sheer volume and detail of the US regulations
indicate, however, that the task is not easy. More significantly, the US
regulations apply only for the purpose of the foreign tax credit limitation.
No country has yet designed rules that match interest expense of a resident taxpayer with foreign source income and restrict the deductibility of
the expense. The reason is probably that the mismatching of interest and
foreign source income involves fundamental questions about the appropriate treatment of direct (using branches) and indirect (using subsidiaries)
85 Paragraph 113(a), which provides a deduction in computing taxable income for dividends paid out of a foreign affiliate’s exempt surplus.
86 See Brian J. Arnold, “The Canadian International Tax System: Review and Reform,”
in this issue of the journal.
87 Tim Edgar, “The Corporate Interest Deduction and the Financing of Foreign Subsidiaries” (1987), vol. 4, no. 4 Australian Tax Forum 491-528.
88 See IRC reg. sections 1.861-9T to 1.861-11T.
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foreign investment, the deductibility of expenses other than interest, the
treatment of debt and equity financing of foreign investment, and relief
from international double taxation. In effect, the entire structure of the
international tax rules of the Canadian income tax system is at issue.89 In
contrast, the mismatching of interest expense and investment income of
individuals is a more limited and easier problem to solve.
89 See,
for example, Lanthier, supra footnote 26.
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