Earlier this month, the Canada Revenue Agency updated its comprehensive folio on the topic of interest deductibility, and while most of the changes aren’t of interest to the average taxpayer, the folio has been revised to add a reference to more recent case law on the meaning of the phrase, “for the purpose of earning income from a business or property.” 

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Borrowing to invest? The CRA just clarified the rules on interest deductibility Back to video

As a refresher, under the Income Tax Act, interest expense is considered to be a capital expense, and is not deductible unless it meets specific requirements. First, it must be an amount paid or payable under a legal obligation to pay interest, and the amount must be reasonable. In addition, when funds are borrowed, the money must have been acquired for the purpose of earning income from a business or earning income from property (i.e. investment income.) 

The updated folio confirmed that the phrase “for the purpose of earning income from a business or property” does not include a reasonable expectation of capital gains, referencing a 2017 Tax Court decision. This concept has caused some confusion among investors who regularly ask about writing off interest expense to buy investments that don’t generate income, and are primarily held to earn a capital gain over time. 

Fortunately, the CRA takes a lenient approach, depending on the facts. For example, where funds are borrowed to make an investment that carries a stated interest or dividend rate, the income-earning test will be met and interest will generally be deductible “absent a sham or window dressing or similar vitiating circumstance.” It’s important to note that the rate or amount of interest or income earned on the investment need not be higher than the interest expense to entitle you to write off the entire expense, nor does it restrict the interest deduction to the amount of income earned. 

For example, if you borrow at five per cent to purchase an investment that only yields three per cent, you can still deduct the entire five per cent interest expense, and aren’t capped by the three per cent income on the investment (absent a sham, etc.) 

Where an investment doesn’t carry a stated interest or dividend rate, such as is the case with most common shares, the CRA generally considers interest costs on funds borrowed to purchase common shares to be tax deductible on the basis that at the time the shares are acquired, “there is a reasonable expectation that the common shareholder will receive dividends.” 

But, the CRA notes, it is conceivable that in certain situations, this reasonable expectation may not be present. For example, if a corporation has stated that it does not pay dividends and that dividends are not expected to be paid in the foreseeable future such that shareholders are required to sell their shares in order to realize their value, the purpose test will not be met and interest won’t be tax deductible if you borrowed to purchase those shares. 

Fortunately, however, the CRA’s administrative position, as detailed in the folio, is that if a corporation is silent with respect to its dividend policy, or its policy is that dividends will be paid “when operational circumstances permit,” the purpose test will be met and interest would generally be deductible on funds borrowed to make those investments. The CRA takes the same position with respect to mutual fund investments. 

In the folio, the CRA provides two examples of common share investments. In the first, X Corp. is an investment vehicle designed to provide only a capital return to the investors in its common shares. Its corporate policy is that dividends will not be paid, that corporate earnings will be reinvested to increase the value of the shares, and that shareholders are required to sell their shares to a third-party in a fixed number of years in order to realize their value. In this situation, since it’s not reasonable to expect any income from such an investment, any interest expense on money borrowed to acquire X Corp. shares would not be deductible. 

By contrast, Y Corp. is raising capital by issuing common shares. Its business plans indicate that its cash flow will be required to be reinvested for the foreseeable future, but it discloses to its shareholders that dividends will only be paid when operational circumstances permit or when it believes that shareholders could make better use of the cash. In this situation, according to the CRA, the income-earning purpose test will be met and any interest on money borrowed to purchase Y Corp. shares would be deductible. 

The folio also reviews a variety of other interest deductibility scenarios that investors may find useful, specifically related to the “use” of borrowed funds. Over the years, the Supreme Court of Canada, through its various decisions, has made it clear that when it comes to interest deductibility, it’s the current use of the funds, and not the original use that’s relevant, meaning that taxpayers must establish a link between the money that was borrowed and its current use, for the interest paid on those borrowed funds to be tax deductible. 

In a simple situation, where one investment is simply replaced with another, linking the original borrowing with its current use is straightforward. As a result, where one investment is sold and the proceeds are used to acquire another investment, interest on the borrowed money that was used to acquire the first investment will continue to be deductible to the extent that the borrowing is reflected in the cost of the new investment. 

For example, let’s say you borrowed funds to buy stock of ABC Corp. You decide to sell those shares and you subsequently use all of the proceeds of the sale to acquire shares of XYZ Inc. In this case, the interest would generally continue to be tax deductible. 

Now, what if the shares of XYZ ultimately become worthless? Would the interest payable on the outstanding loan still be deductible, even in an extreme case where XYZ Inc. has filed for bankruptcy and eventually no longer exists? 

You may be surprised to learn that the answer is yes. Under the “disappearing source” rules, also discussed in the folio, where borrowed money was originally used for the purpose of earning income but it can no longer be traced to any income earning use, under the tax act, the borrowed money is nonetheless deemed to be used for the purpose of earning income which enables interest on this amount to continue to be tax deductible. 

Jamie Golombek, FCPA, FCA, CFP, CLU, TEP, is the managing director, Tax & Estate Planning with CIBC Private Wealth in Toronto. Jamie.Golombek@cibc.com.

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