The Canada Revenue Agency (CRA) recently released an updated folio publication on the topic of interest deductibility. This is part of the CRA’s new Income Tax Folio series, which is designed to provide details of their current administrative practices and is targeted at the professional tax community. Folio S3-F6-C1, released in 2015, sets out the CRA’s position on the deductibility of interest expense under paragraph 20(1)(c) of the Income Tax Act (“ITA”) along with related provisions. The predecessor document, Bulletin IT-533 – Interest Deductibility and Related Issues, was originally issued in 2003. Generally, interest expense is considered to be a capital expenditure and is deductible only if it meets the specific requirements as set out in the ITA. The provision that allows the deduction of interest expense, paragraph 20(1)(c), appears relatively straightforward but differences in interpretation often lead to wording being argued before the courts. The general principles for interest deductibility include the following:
- The interest amount must be paid or payable in a taxation year.
- There must be a legal obligation to pay the interest amount.
- The money must be borrowed for the purpose of earning income from a business or property (even if that income does not materialize), but this provision excludes interest on money borrowed to acquire a life insurance policy and limits the amount deductible in respect of money borrowed to purchase an annuity.
- The deductible amount must be reasonable in the circumstances.
As noted in point three above, the provision includes a purpose test. In simple terms, this purpose test obligates the taxpayer to demonstrate how the funds were utilized, and has been the subject of significant litigation over the years. The new folio reflects precedents arising from court decisions such as Ludco Enterprises Ltd. et al. v The Queen. In Ludco, the Supreme Court of Canada confirmed a taxpayer’s ancillary purpose is an acceptable purpose to allow for deductibility of an interest expense. The term “used” is interpreted to mean used directly or indirectly, again based on case law precedents.
Borrowing To Purchase An Annuity
As noted above, interest on money borrowed to purchase an annuity may be deductible in certain circumstances. Specifically, the annuity must be subject to annual accrual taxation, and if regular annuity payments have commenced under the contract, the interest deduction is limited to the amount of income that is included in the taxpayer’s income under the accrual taxation rules. Note that many annuities automatically qualify as “prescribed annuity contracts” once they enter into their payout phase, with the result that interest will no longer be deductible on these contracts unless the policyholder elects out of prescribed annuity treatment.
Borrowing to Buy Common Shares
The folio requires that the “purpose” test be met in order for interest expense to be tax deductible. Formerly, this was known as the “reasonable expectation” test. The CRA’s position is that generally interest on funds borrowed to purchase common shares is a deductible expense, provided there is a reasonable expectation of dividends payable on the shares. The purpose test cannot be met if the company has a stated policy of NOT paying dividends. In situations where the company has never paid dividends, the purpose test can generally be met as long as the company policy is silent with respect to dividends, or if the policy provides that the company will pay dividends when operational circumstances permit.
A participation interest payment might be part of a legal agreement to pay interest or ‘extra’ interest calculated with reference to profits, revenues, cash flow, etc. To be treated as interest, there must be a legal obligation to pay the amount and it must be in respect of the amount borrowed.
There is a specific provision that denies the deduction of compound interest until it is actually paid. Compound interest is interest on interest – in other words, it is interest arising on a balance of interest payable that has been added to an existing loan (or “capitalized”) rather than being paid. Adequate records will be required to separate the basic interest that becomes payable and deductible from the compound interest that is not deductible until actually paid. The folio confirms the CRA’s practice of allowing interest on a second loan incurred to pay the interest on the first loan to be deducted for tax purposes.
The taxpayer must be able to trace the use of the borrowed funds to an eligible purpose. This is usually relatively easy when the funds are first borrowed. Complexity can arise if the income-producing property is sold and replaced with another property. If the purpose of the second property acquired is to gain or produce income, then the interest on the loan continues to be tax deductible. Borrowing funds can be key to business expansion or portfolio diversification and the deductibility of the associated interest will be important to the taxpayer in assessing the overall after-tax rate of return. The CRA’s interest deductibility folio provides insight and some certainty into their administrative positions.
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Copywrite ISSN 0382-7038 Julyé Aug 2015
Contributors to this edition:
James W. Kraft, cpa, ca, mtax, tep, cfp, clu, ch.f.c.
Deborah Kraft, mtax, tep, cfp, clu, ch.f.c.