By: Fabio Campanella CPA, CA, CFP, CIM
Knowing when you can or can’t deduct interest for tax purposes can get tricky. Often, taxpayers (and their accountants) get it wrong. This can lead to hefty penalties and interest from tax reassessments, along with surprise tax bills. What’s more, taxpayers and their accountants often miss planning opportunities to restructure debts to create tax-sheltered options.
So when can you deduct interest? Let’s walk through the basic rules:
1: There must be a legal obligation to pay the interest:
There must be no contingency or uncertainty with the requirement to pay the interest, it must be a legal obligation. Often, this means that the counterparty collecting the interest must claim the interest as taxable income. Although a written agreement is recommended an oral arrangement may suffice. For an oral arrangement to actually work the CRA or the Tax Court of Canada would have to be convinced that the arrangement is real (see Conrad Black v. The Queen, 2019 TCC 135)
2: The deduction must be reasonable:
If you’ve worked in tax for long enough then you see this word, reasonable, pop up over and over. What does it mean? Well, it means different things in different situations. Let’s look at a hypothetical example using related parties:
Mrs. A who pays tax in the highest tax bracket (53%) borrows $100,000 from her spouse, Mr. A, who pays tax at the lowest marginal rate (20%). Mrs. A has no other debts, many assets, and a credit score of 800. Mr. A charges Mrs. A 18% interest per year and claims the interest as taxable income leading to $3,600 in tax payable. Mrs. A invests the $100,000 in GICs earning 2% interest income. Mrs. A attempts to take the annual interest paid to Mr. A as a carry charge against her investment income leading to an $18,000 deduction and a tax savings of $9,540. The net tax benefit to the family is $5,940.
Sounds “reasonable”? Of course not. Why would Mrs. A pay loan-shark rates of interest when she has the ability to obtain a secured line of credit from a reputable financial institution at much lower rates? A scenario like this would likely be seen as unreasonable and disallowed.
3: The interest is paid on borrowed money used for the purpose of earning INCOME that is subject to tax:
Both the CRA and the courts will look for a direct, traceable connection between the borrowed funds and the use of those funds to invest in something that will at least have the ability to pay dividends, interest, rents, royalties, or business income. You would need to show a direct connection between the borrowings and the source of taxable income, it’s not enough to argue that you had to borrow to pay personal expenses (groceries, etc.) to avoid selling investments, the connections must be very clear.
The examples and guidelines above just scratch the surface of this complex topic. In addition, the Income Tax Act prohibits deductions for interest on loans taken out specifically to invest in RRSPs, TFSAs, RESPs along with a host of other more complex situations.
Fabio Campanella CPA, CA, CFP, CIM is a founding partner of Campanella McDonald LLP. He is a tax specialist, an investment advisor, and an estate and life insurance advisor licensed in the Province of Ontario. His practice focuses on building tax-efficient retirement and estate plans for entrepreneurs, retirees, and high-income earning professionals. You can access his website by clicking HERE.