Accountant Companion: Navigating Canadian Interest Deductibility for Investment Loans

(Part of the Taxevity Navigator Series)

1. Introduction for Accountants

As a Canadian accountant, your clients often rely on your expertise to navigate the complexities of the Income Tax Act, including the rules surrounding interest deductibility for investment loans. This Companion is designed to complement your own research and due diligence by providing a consolidated overview of key legislative provisions, Canada Revenue Agency (CRA) administrative positions, and relevant court decisions concerning interest deductibility as of mid-2025.

The financial landscape is ever-evolving, and strategies involving leverage, such as Immediate Financing Arrangements (IFAs), require careful consideration (see IFAs: An Accountant’s Guide to Client Suitability and Due Diligence). This resource aims to help you identify critical areas for analysis when advising clients on these matters. It is intended to complement, not replace, your professional judgment and the detailed examination of specific client circumstances.

Ultimately, this Companion seeks to assist you in guiding your clients effectively, ensuring that any strategies involving borrowed funds for investment are understood from a tax perspective, align with compliance requirements, and serve their overall financial objectives.

2. Deep Dive: Income Tax Act (Canada) Section 20(1)(c)

Understanding the precise wording of paragraph 20(1)(c) of the Income Tax Act (ITA) is fundamental to advising on interest deductibility. This section provides the legislative basis for deducting interest expenses.

2.1. Detailed Legislative Analysis: Conditions and Sub-clauses

Paragraph 20(1)(c) of the ITA states:

“Notwithstanding paragraphs 18(1)(a), (b) and (h), in computing a taxpayer’s income for a taxation year from a business or property, there may be deducted such of the following amounts as are wholly applicable to that source or such part of the following amounts as may reasonably be regarded as applicable thereto…

(c) an amount paid in the year or payable in respect of the year (depending on the method regularly followed by the taxpayer in computing the taxpayer’s income), pursuant to a legal obligation to pay interest on

(i) borrowed money used for the purpose of earning income from a business or property (other than borrowed money used to acquire property the income from which would be exempt or property that is an interest in a life insurance policy),

(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 or property that is an interest in a life insurance policy)…

(ii.1) an amount paid to a person or partnership by the taxpayer in the course of incurring indebtedness that is 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 or property that is an interest in a life insurance policy)…

(Note: Subparagraphs (iii) and (iv) dealing with specific government assistance and certain annuity contracts are less commonly encountered in general investment loan scenarios and are not detailed here for brevity but should be consulted if applicable.)

…or a reasonable amount in respect thereof, whichever is the lesser;”

Core Conditions for Deductibility:

Several core conditions, derived from the preamble and the subparagraphs of 20(1)(c), must be met:

• Amount Paid or Payable: The interest must be paid in the year or payable in respect of the year, depending on the taxpayer’s accounting method (cash or accrual).
• Legal Obligation: The amount must be paid pursuant to a legal obligation to pay interest. This obligation must be absolute and non-contingent.
• Purpose of Earning Income:
  • For borrowed money (subparagraph (i)), it must be used for the purpose of earning income from a business or property.
  • For an amount payable for property (subparagraph (ii)), the property must have been acquired for the purpose of gaining or producing income from that property or from a business.
• Reasonableness: The amount of interest claimed must be reasonable. This is typically assessed by reference to prevailing market rates for debts with similar terms and credit risks.
• Exclusions: Interest is not deductible if the borrowed money is used to acquire property whose income would be exempt, or, significantly, to acquire a life insurance policy (subject to certain exceptions, such as some policy loans meeting specific conditions or certain annuity contracts).

Analysis of “Interest”:

The ITA does not define “interest”. Consequently, reliance is placed on the common law definition, which has been accepted by the CRA and Canadian courts. Generally, for an amount to be considered interest, it must be:

• Compensation for the use or retention of money owed to another.
• Referable to a principal sum or an ascertainable principal sum.
• Accrue on a day-to-day basis.

The CRA’s Income Tax Folio S3-F6-C1, Interest Deductibility, elaborates on this, noting that participating payments (payments computed by reference to profit, revenue, or cash flow) are generally not considered interest unless specific conditions are met, such as the payment being limited to a stated percentage of the principal that reflects prevailing arm’s-length commercial interest rates, and no other facts suggest an equity investment.

Analysis of “Legal Obligation”:

For interest to be deductible, it must be incurred pursuant to a legal obligation to pay it. The CRA considers an expense to be generally incurred when there is a legal obligation to pay a sum of money and the liability is absolute and non-contingent. Deferring payment does not make it contingent, but if the obligation’s existence depends on a future event, it is contingent and generally not deductible until the contingency is met.

Analysis of “Reasonable Amount”:

The interest deduction is limited to a reasonable amount. Reasonableness is a question of fact, determined by considering factors such as prevailing market interest rates for debts with similar terms and credit risks at the time the debt was incurred. An interest rate established in an arm’s-length market is generally considered reasonable.

2.2. Common Interpretative Challenges and Nuances for Tax Practitioners

Navigating paragraph 20(1)(c) involves understanding several interpretative challenges and nuances that frequently arise in practice.

• Distinction between subparagraph 20(1)(c)(i) and (ii): A critical distinction lies between interest on “borrowed money” under (c)(i) and interest on an “amount payable for property acquired” under (c)(ii). “Borrowed money” implies a lender-borrower relationship and the existence of a loan. An unpaid purchase price for property is not “borrowed money” but an “amount payable for property”. This distinction is particularly relevant when a taxpayer assumes another person’s indebtedness as part of a property acquisition; in such cases, interest may be deductible under (c)(ii) rather than (c)(i).
• Compound Interest: Simple interest is deductible under paragraph 20(1)(c) when paid or payable (depending on the accounting method). However, compound interest (interest on interest) is only deductible under paragraph 20(1)(d) and only in the year it is actually paid, regardless of the taxpayer’s accounting method. If accrued simple interest is added to the principal of an existing loan, creating a new obligation (novation), a portion of the interest on the new loan will be compound interest, deductible only when paid.
• Contingent Interest: Generally, interest that is contingent upon a future event is not considered payable (for accrual taxpayers) or a legal obligation until the contingency occurs. Thus, its deductibility is deferred.
• Interaction with other ITA provisions: Paragraph 20(1)(c) does not operate in isolation. It is crucial to consider its interaction with other provisions of the ITA. For example:
  • Paragraph 18(1)(b) generally prohibits the deduction of outlays on capital account unless expressly permitted by another provision in Part I of the Act. Paragraph 20(1)(c) provides such an express permission for interest that meets its criteria.
  • Subsection 18(2) restricts the deductibility of interest and property taxes on vacant land or land held as inventory by developers, generally limiting the deduction to the net income from the land for the year. Non-deductible amounts are typically added to the cost of the land.
  • Subsection 18(3.1) requires that “soft costs,” including interest, incurred during the period of construction, renovation, or alteration of a building be capitalized to the cost of the building, rather than deducted currently. These interactions highlight that even if interest meets the basic tests of 20(1)(c), other provisions may limit or deny its deduction.

3. Comprehensive Review: CRA Income Tax Folio S3-F6-C1 (“Interest Deductibility”)

Income Tax Folio S3-F6-C1 (Interest Deductibility) is the CRA’s primary administrative document outlining its technical interpretations and positions on paragraph 20(1)(c) and related provisions. While Folios are not law, they represent the CRA’s assessing practice and are highly influential. Accountants must be thoroughly familiar with the Folio’s contents to provide effective client advice and prepare tax returns robustly. Practitioners should always refer to the most current version.

3.1. Key CRA Positions: Detailed Examination

The Folio provides detailed commentary on the core requirements for interest deductibility:

• Definition of Interest: The CRA reiterates its acceptance of the common law definition: an amount calculated on a day-to-day accrual basis, on a principal sum, as compensation for the use of that sum. It also discusses participating payments, noting they may qualify as interest if they are limited by a stated percentage of principal reflecting market rates and do not otherwise resemble an equity return. Section 16 can deem an amount to be interest if it can reasonably be regarded as such, even if not explicitly identified as interest in an agreement.
• Legal Obligation: The interest must be “paid in the year or payable in respect of the year… pursuant to a legal obligation to pay interest.” Cash method taxpayers deduct when paid; accrual method taxpayers deduct when accrued. An expense is generally incurred when a legal obligation to pay is absolute and non-contingent. Section 143.4 may affect deductibility if a taxpayer has a right to reduce or eliminate the payment obligation.
• Reasonable Amount: The deduction is limited to the lesser of the actual amount and a reasonable amount, determined by prevailing arm’s-length market rates for comparable debts.
• Use of Borrowed Money (Subparagraph 20(1)(c)(i)):
  • Direct Use Test: The Supreme Court of Canada has established that the direct use of borrowed funds is the primary test. The taxpayer bears the onus of tracing the funds to a specific eligible use.
  • Current Use vs. First Use: The current use of the borrowed money is relevant, not its original use. A link must be established between the borrowed money and its current application.
  • Tracing/Linking:
    • Simple Replacement: If one income-earning property is sold and proceeds are used to acquire another, the link is straightforward.
    • Multiple Replacement Properties: A flexible approach allows allocation of the debt to replacement properties on a dollar-for-dollar basis. If replacement property values are less than the debt, a pro-rata allocation is required.
    • Cash Damming: Segregating borrowed funds (e.g., in a separate bank account) from other cash facilitates tracing and is accepted by the CRA as a way to demonstrate specific eligible uses. This is a best practice for clarity.
    • Commingled Funds: If borrowed money is mixed with other funds, the taxpayer can generally choose to link the borrowed money to eligible expenditures made from the commingled pool, provided the borrowing occurred before or at the same time as the expenditure. A specific use cannot be linked to a subsequent borrowing.
    • Repayment of Commingled Borrowings: When repaying a single loan account used for both eligible and ineligible purposes (e.g., a mixed-use line of credit), any principal repayment is considered to reduce both the eligible and ineligible portions of the loan proportionally. Taxpayers cannot selectively allocate repayments to the ineligible portion first. This is a common area of misunderstanding.
  • Indirect Use Exceptions: In “exceptional circumstances,” courts have accepted indirect use. This applies when a “real appreciation of a taxpayer’s transactions” suggests that allowing a deduction for funds borrowed for an ostensibly ineligible use is appropriate due to an indirect positive effect on the taxpayer’s income-earning capacity. Key examples include:
    • Redeeming Shares, Returning Capital, or Paying Dividends (The “Filling the Hole” Concept): Interest on money borrowed by a corporation for these purposes may be deductible if the borrowed funds replace capital (contributed capital or accumulated profits) that was being used for eligible, income-earning purposes. The borrowed money is seen as “filling the hole” left by the withdrawn capital that was productively employed. This is a crucial concept for corporate finance.
    • Interest-Free Loans and Capital Contributions: Generally, interest on money borrowed to make an interest-free loan is not deductible. However, if such a loan (e.g., to a wholly-owned subsidiary) demonstrably increases the lender’s capacity to earn income (e.g., by enabling the subsidiary to pay more dividends to the parent), the interest may be deductible as an indirect eligible use. The same logic can apply to capital contributions.
• Purpose of Earning Income (including Reasonable Expectation of Income – REOI):
  • The borrowed money must be used “for the purpose of earning income from a business or property.” This is a question of fact.
  • The Supreme Court in Ludco Enterprises Ltd. et al. v The Queen established the test: whether the taxpayer had a reasonable expectation of income at the time the investment was made. An ancillary income-earning purpose can be sufficient, provided it is a bona fide objective and not a sham or window dressing.
  • Definition of “Income”: “Income” in this context means income that would be subject to tax (e.g., interest, dividends, rent), not necessarily net income or profit. Courts are generally not concerned with the sufficiency of the income, provided there is a reasonable expectation of earning some income.
  • Capital Gains Exclusion: The purpose of earning income does not include an expectation of capital gains. Investments made solely for capital appreciation without any expectation of income (interest, dividends, etc.) will fail this test.
  • Common Shares: If shares have a stated dividend rate, the test is usually met. For common shares without a stated rate (e.g., most publicly traded shares), the CRA generally considers interest deductible if there was a reasonable expectation of receiving dividends at the time of acquisition. This expectation can exist even if dividends are not currently being paid, provided the company’s policy or circumstances suggest future dividends are possible. However, if a corporation explicitly states it will not pay dividends and shareholders must sell shares to realize value, the purpose test is not met. The Swirsky case highlighted the challenges where there’s a history of no dividends and no clear policy to pay them.
• Specific Types of Property:
  • Life Insurance Policy: Interest on borrowed money used to acquire a life insurance policy (as defined in subsection 138(12)) is specifically denied deduction under subparagraphs 20(1)(c)(i) and (ii). This is distinct from using a policy as collateral for a loan to make a separate income-earning investment.
  • Property Producing Exempt Income: Interest on funds borrowed to acquire property whose income would be exempt from tax is not deductible.
  • “10/8 Policies”: For tax years ending after March 20, 2013, subsection 20(2.01) specifically denies interest deductions on “10/8 policies,” which are leveraged life insurance arrangements designed to create an annual interest expense deduction by linking policy returns to borrowing costs.

3.2. Implications of the Folio for Client Advice and Tax Return Preparation

The positions articulated in Income Tax Folio S3-F6-C1 directly shape the advice accountants must provide. When clients consider leveraged investments, accountants should explain the direct use, purpose, and tracing rules as interpreted by the CRA. For instance, the Folio’s acceptance of “cash damming” or its specific stance on repaying commingled lines of credit are practical points that influence structuring advice.

For tax return preparation, the Folio underscores the type and extent of documentation required to support an interest deduction claim. While Folios are administrative interpretations and not statutory law, they carry significant weight with CRA auditors. Deviating from a clear Folio position without a strong, well-researched legal basis is likely to invite reassessment. Therefore, accountants should use the Folio as a guide for proactive planning to ensure compliance and to build a robust defence should a claim be queried. The dynamic nature of CRA guidance means accountants must stay vigilant for updates and revisions to Folios to ensure their advice remains current.

4. The “Purpose of Earning Income” Test for Accountants

The cornerstone of interest deductibility under subparagraph 20(1)(c)(i) is that the borrowed money must be “used for the purpose of earning income from a business or property.” The interpretation of this phrase, particularly the “purpose” element, has been significantly shaped by Canadian courts.

4.1. In-depth Analysis: The REOI Principle and Landmark Jurisprudence

Initially, some interpretations focused on a more general bona fide purpose. However, the Supreme Court of Canada has clarified the test, centering it on the Reasonable Expectation of Income (REOI).

• Ludco Enterprises Ltd. et al. v. The QueenThis 2001 Supreme Court of Canada decision is pivotal.
  • Key Facts: The taxpayers borrowed substantial funds to purchase shares in foreign companies. Over several years, they received relatively nominal dividend income while incurring significant interest costs. The Minister of National Revenue disallowed the interest deductions, arguing the primary purpose of the borrowing was tax deferral and the eventual realization of capital gains, not earning income.
  • Court’s Reasoning and Test Established: The Supreme Court allowed the appeal, establishing that the requisite test for the purpose requirement in subparagraph 20(1)(c)(i) is “whether, considering all the circumstances, the taxpayer had a reasonable expectation of income at the time the investment was made.” Key principles from Ludco include:
    • “Income” means gross income: The Court clarified that “income” in this context refers to income that is subject to tax (e.g., dividends, interest), not net income or profit. Therefore, an expectation of gross revenue is sufficient, even if expenses (like interest) exceed that revenue.
    • Ancillary purpose is sufficient: The income-earning purpose does not need to be the exclusive, primary, or dominant purpose. An ancillary or secondary purpose of earning income can satisfy the test, provided it is a bona fide, actual, real, and true objective of the investment, absent a sham, window dressing, or other vitiating circumstances.
    • Sufficiency of income not a concern: Courts should not be concerned with the amount or sufficiency of the income expected or received, as long as there is a reasonable expectation of some income. An “economic realities” test that would compare income to interest costs was rejected as inconsistent with the statutory language.In Ludco, despite the disparity between dividends and interest costs, the Court found that the taxpayers did anticipate and receive dividend income, and the investments were genuine.
• Swirsky v. R.This 2014 Federal Court of Appeal (FCA) decision provides an important application and, some argue, a tempering of the Ludco principles, particularly for investments in shares that are not currently paying dividends.
  • Key Facts: Ms. Swirsky borrowed funds to acquire common shares in a family-owned corporation. The corporation had a history of not paying dividends, and there was no formal dividend policy in place indicating an intention to pay dividends in the future. The Minister disallowed the interest deduction, arguing no reasonable expectation of income.
  • Court’s Reasoning (FCA): The FCA upheld the Tax Court’s decision to disallow the interest deduction. It affirmed the Ludco test (REOI at the time of investment) but emphasized that the determination of REOI is an objective assessment based on all circumstances. The Court found that, on the facts, Ms. Swirsky had failed to demonstrate an objectively reasonable expectation of earning income (dividends) from the shares at the time of acquisition. Factors considered included the historical absence of dividend payments, the lack of a dividend policy, and how the family historically extracted funds from the company (via shareholder loans and bonuses, not dividends).
  • Implications: Swirsky underscores that a mere subjective hope or assertion of expecting income is insufficient. There must be objective evidence to support that expectation. For shares in private companies or those not currently paying dividends, the evidential burden on the taxpayer is higher. While Ludco established that current dividend payment isn’t strictly necessary if there’s a future expectation, Swirsky demonstrates that such an expectation must be grounded in objective facts and circumstances.

The CRA, in Folio S3-F6-C1, adopts the Ludco test, stating that “the test is whether the taxpayer had a reasonable expectation of income at the time the investment was made” and that an ancillary purpose can be a bona fide objective. However, the Folio also reflects the caution from Swirsky, particularly in its examples concerning common shares where a corporation has an explicit policy not to pay dividends (in which case, the purpose test is not met) versus a policy of paying dividends when circumstances permit (purpose test generally met).

Other relevant jurisprudence includes Shell Canada Limited v. The Queen (confirming the common law definition of interest and emphasizing the direct use test), Bronfman Trust v. The Queen (addressing direct versus indirect use of borrowed funds), and Singleton v. Canada (focusing on the characterization of the use of borrowed funds). These cases collectively shape the interpretative landscape for interest deductibility.

4.2. Evidentiary Requirements: Assessing Client’s Stated Purpose

The REOI test is applied “at the time the investment was made.” This places significant importance on contemporaneous evidence. Accountants play a crucial role in advising clients on the need to scrutinize and document their investment purpose.

• Objective Evidence: This carries the most weight. Examples include:
  • The investee corporation’s dividend payment history.
  • The investee corporation’s formal dividend policy (e.g., in corporate resolutions, annual reports).
  • Investment prospectuses, offering memorandums, or analyst reports detailing expected income distributions.
  • Contemporaneous minutes of investment committee meetings or personal investment notes outlining the income expectation.
  • For rental properties, market rent analyses and cash flow projections.
• Subjective Evidence: A client’s testimony about their intention to earn income is relevant but will generally be insufficient if not supported by objective factors. The Swirsky case serves as a clear example where the lack of objective evidence supporting an expectation of dividends was fatal to the interest deduction claim. Accountants must impress upon clients, especially when investing in non-traditional assets or private company shares with no dividend history, the critical need to document the basis for their reasonable expectation of income at the outset. This proactive documentation can be invaluable if the CRA later questions the purpose.

4.3. Distinguishing Income (Interest, Dividends) from Capital Gains

A fundamental aspect of the “purpose of earning income” test is that paragraph 20(1)(c) requires a purpose to earn income (such as interest, dividends, or rent), not capital gains. The CRA’s Folio S3-F6-C1 explicitly states: “the phrase ‘for the purpose of earning income from a business or property’ does not include a reasonable expectation of capital gains”.

This distinction has significant implications:

• Investments Aimed Solely at Capital Appreciation: If borrowed funds are used to acquire an investment that is reasonably expected to generate only capital gains, with no prospect of producing interest, dividends, or other forms of income, the interest on the loan will generally not be deductible. Examples could include speculative vacant land held purely for resale or certain types of growth stocks where the company has a stated policy of reinvesting all earnings and never paying dividends.
• Low Income Yield, High Capital Gains Potential: Ludco established that an ancillary income purpose can be sufficient, and courts should not be concerned with the sufficiency of income. This offers some flexibility. If an investment has a low current income yield (e.g., a growth stock that pays a very small dividend) but a high potential for capital gains, the interest may still be deductible if there is a reasonable expectation of earning that (albeit small) amount of income. However, a complete absence of any income expectation, with reliance solely on capital gains, will likely fail the test.

Accountants must carefully question clients about their expectations. If the investment strategy is overwhelmingly or exclusively focused on capital appreciation, with little or no documented basis for expecting income distributions, the deductibility of interest is at significant risk.

5. Tracing, Documentation, and Compliance – An Accountant’s Perspective

The ability to substantiate an interest deduction claim hinges critically on the taxpayer’s ability to trace the use of borrowed funds to an eligible income-earning purpose and to maintain comprehensive documentation. The onus is squarely on the taxpayer to provide this evidence.

5.1. Advising on Record-Keeping for Interest Deductions

Accountants must proactively advise clients on the stringent record-keeping requirements from the inception of any leveraged investment strategy. Inadequate records are a common reason for the CRA to deny interest deductions.

Essential documentation includes, but is not limited to:

• Loan Agreements: Clearly outlining the terms of the borrowing, interest rate, and repayment schedule.
• Bank Statements: Showing the receipt of borrowed funds and their subsequent disbursement.
• Investment Purchase Confirmations: Brokerage slips, purchase agreements for property, etc., demonstrating the acquisition of the specific income-earning asset.
• Brokerage/Investment Account Statements: Showing the ongoing holding of the investment and any income received.
• T-slips (T3, T5, T5013, etc.): Evidencing the receipt of taxable income (interest, dividends, rental income, partnership income) from the investment.
• Ledgers for Commingled Accounts: If borrowed funds are temporarily mixed with other funds, detailed records tracking the flow of funds are essential.
• Corporate Dividend Policies/Resolutions: For investments in private company shares, evidence of a policy or intention to pay dividends.
• Correspondence/Notes: Contemporaneous notes or correspondence detailing the investment strategy and income-earning expectation at the time of borrowing.
• Calculations for Interest Allocation: Where funds are commingled or a loan is used for multiple purposes, clear calculations supporting the portion of interest claimed.

While the client is responsible for maintaining these records, the accountant’s role is to provide clear guidance on what documents are necessary, how they should be organized, and the potential consequences of failing to do so.

5.2. Navigating Commingled Funds and Complex Financial Arrangements

Tracing borrowed funds becomes more challenging when they are mixed with other monies or used in complex structures. The CRA provides specific guidance in Folio S3-F6-C1 on these scenarios:

• CRA’s Flexible Approach to Tracing Commingled Funds: When borrowed money and other cash are deposited into the same account, the CRA generally permits taxpayers to choose to link the use of the borrowed money to specific eligible expenditures made from that commingled account (the “flexible approach”). However, this flexibility is subject to important timing considerations:
  • The approach is only applicable when funds are actually commingled.
  • A specific use of money can never be linked to a borrowing that occurs subsequently. The borrowing must precede or be contemporaneous with the expenditure. The CRA generally accepts same-day transactions as meeting this timing requirement.
• Cash Damming: This is a strategy where a taxpayer structures their finances to maximize the direct link between borrowed funds and deductible expenses, while using non-borrowed funds (e.g., business revenues) for non-deductible expenses. This typically involves using separate bank accounts for borrowed funds (used for income-earning purposes) and other cash flows (used for personal expenses or to pay down personal debt). The CRA accepts that cash damming techniques, when properly implemented, facilitate the tracing process and are consistent with paragraph 20(1)(c) and court decisions. This is often a recommended best practice for clarity.
• Repayment of Commingled Borrowings: The flexible approach to tracing does not apply to the repayment of borrowed money from a single borrowing account (e.g., line of credit, mortgage) that has been used for both eligible and ineligible purposes. The CRA’s position is that any principal repayment reduces the portions of the loan used for both eligible and ineligible purposes proportionally. Taxpayers cannot choose to allocate repayments solely to the ineligible portion of the loan to preserve deductibility on the eligible portion. This is a frequent point of error and can lead to a gradual reduction in deductible interest if not managed correctly.
• Lines of Credit Used for Multiple Purposes: These require extreme diligence. Each draw must be traced to its specific use. If a line of credit is used for investments, business expenses, and personal expenses, meticulous ongoing records and interest allocation calculations are essential.
• Return of Capital (ROC) from Mutual Funds/ETFs: If borrowed money is used to purchase mutual funds or ETFs, and these investments later make distributions classified as ROC, these ROC amounts effectively reduce the amount of borrowed money still invested in an income-earning source. To maintain full interest deductibility on the original loan amount, the ROC received should ideally be used to pay down the investment loan or be reinvested in another eligible income-earning investment. Using ROC for personal purposes without adjusting the loan balance can “poison” the deductibility of interest on that portion of the loan.

5.3. Preparing for and Responding to CRA Queries and Audits Related to Interest Expense Claims

Audit readiness is a critical component of advising on leveraged strategies. Accountants should prepare clients for the possibility of CRA scrutiny, especially for large or complex interest expense claims.

• Common CRA Audit Triggers for Interest Expense:
  • Large or unusual interest expense claims relative to income or industry norms.
  • Inconsistencies between tax filings and third-party information.
  • Complex leveraged investment arrangements, including IFAs.
  • History of prior tax non-compliance.
  • Significant changes in shareholder loan accounts.
  • Business or rental schedules showing large amounts of interest, advertising, travel, or miscellaneous expenses.
• CRA Auditor Focus: When reviewing interest deductions, CRA auditors typically focus on:
  • Direct Link/Tracing: Verifying the clear path of borrowed funds from the lender to the specific income-earning investment. This is often the first and most critical hurdle.
  • Reasonable Expectation of Income (REOI): Assessing whether the investment had a reasonable prospect of generating taxable income (not just capital gains) at the time the loan was taken.
  • Reasonableness of Interest Rate: Ensuring the interest rate is consistent with arm’s-length market rates.
  • Nature of the Investment: Confirming the investment is capable of producing income (e.g., dividend-paying shares, interest-bearing bonds, rental property).
  • Documentation: Reviewing the adequacy and completeness of supporting documents (loan agreements, bank statements, investment statements, T-slips, etc.). Form T2210 may be required for certain policy loan interest.
• Proactive Steps for Audit Preparedness:
  • Robust Documentation: Ensure all necessary documents (as listed in 5.1) are gathered, organized, and readily available from the outset.
  • Clear Audit Trail: Maintain records that clearly demonstrate the flow of funds and the link to income-earning activities.
  • Tax Position Memos: For complex strategies (like IFAs or significant corporate reorganizations involving leverage), prepare a contemporaneous memorandum outlining the facts, the tax analysis supporting the interest deduction (referencing relevant ITA provisions, Folio paragraphs, and case law), and the REOI.
  • Regularly review leveraged positions with clients, especially if circumstances change (e.g., investment sold, ROC received).
• Responding to CRA Queries and Audits:
  • Understand the Scope: Carefully review the CRA’s initial letter to understand which years and specific items are under review. Clarify any ambiguities with the auditor.
  • Timeliness and Cooperation: Respond to CRA requests for information promptly, completely, and politely. A cooperative attitude can facilitate a smoother audit process.
  • Professional Representation: The accountant often plays a key role in liaising with the CRA, explaining the transactions, and providing the requested documentation. In complex audits, involving a tax lawyer may also be advisable.
  • Review Returns: Before meeting with auditors, review the tax returns in question and the supporting documentation to anticipate questions and identify any potential issues.
  • Accuracy: Ensure all information provided to the CRA is accurate and complete.

By implementing these practices, accountants can significantly enhance their clients’ ability to sustain interest deduction claims upon CRA review.

Table 1: Documentation Checklist for Interest Deductibility Claims

This checklist provides a practical tool for accountants to guide clients in gathering and maintaining the necessary documentation, thereby significantly improving audit readiness and the likelihood of successfully sustaining interest deduction claims.

6. Eligible Uses of Borrowed Funds – Tax Implications

The deductibility of interest under paragraph 20(1)(c) is fundamentally tied to the use of the borrowed funds. The funds must be employed for the purpose of earning income from a business or property, and that income must generally be taxable in Canada.

6.1. Traditional Investments (Shares, Bonds, Mutual Funds, Rental Properties)

• Shares: Interest on money borrowed to acquire common or preferred shares is generally deductible if, at the time of acquisition, the taxpayer had a reasonable expectation of earning dividend income. As established in Ludco, this expectation does not require that dividends be paid immediately, nor does the expected dividend income need to exceed the interest expense. However, if a corporation has an explicit and clear policy of not paying dividends, and its structure is such that shareholders can only realize value through capital appreciation upon sale, the REOI test for dividend income may not be met, potentially jeopardizing interest deductibility (as seen in Swirsky). Accountants should advise clients to document the basis for their dividend expectation, especially for private company shares or growth stocks with low or no current dividend yield.
• Bonds & GICs: For fixed-income securities like bonds and Guaranteed Investment Certificates (GICs), the purpose of earning interest income is usually straightforward and well-documented, making the associated borrowing costs generally deductible, provided the interest income is taxable.
• Mutual Funds/ETFs: When borrowed funds are used to invest in mutual funds or Exchange Traded Funds (ETFs), the nature of the fund’s distributions is critical. If the fund primarily distributes taxable income (interest, dividends, foreign income), the purpose test is likely met. However, a significant complication arises with distributions classified as Return of Capital (ROC). ROC is not considered “income” for the purpose of 20(1)(c). If a taxpayer receives ROC distributions from a leveraged investment and uses those funds for personal purposes (rather than repaying the loan or reinvesting in an income-earning asset), the portion of the loan corresponding to the ROC may no longer be considered used for an income-earning purpose. This can lead to a pro-rata denial of interest deductibility on the loan. Clients should be advised to track ROC distributions carefully and manage their loan balances or reinvestments accordingly to preserve interest deductibility.
• Rental Properties:
  • Interest on a mortgage or loan taken to acquire an income-producing rental property is generally deductible against rental income.
  • Personal Use Portion: If a portion of the property is used personally by the owner (e.g., renting out a basement suite in a principal residence), the interest expense (and other property expenses) must be apportioned. Only the portion related to the income-earning rental space is deductible. This apportionment is typically based on square footage or the number of rooms rented.
  • Reasonable Expectation of Profit (REOP): While the REOI test for interest deductibility focuses on gross income, the ability to claim rental losses (where expenses exceed income) generally requires an overall reasonable expectation of profit from the rental activity itself. Renting a property to a relative at a rate below fair market value, resulting in consistent losses, may lead the CRA to challenge the deductibility of those losses, and potentially the interest component if the activity is not seen as a genuine commercial endeavor.
  • Documentation: Taxpayers must maintain detailed records of rental income and all expenses, including mortgage statements. Form T776, Statement of Real Estate Rentals, is used to report rental income and expenses.
  • Soft Costs: Interest and other “soft costs” (e.g., legal fees, accounting fees, property taxes) incurred during the construction, renovation, or alteration period of a rental property may be subject to capitalization rules under subsection 18(3.1) or specific CCA rules, rather than being immediately deductible as current expenses.

6.2. Insurance Leveraging Strategies (Focus on IFAs)

Immediate Financing Arrangements (IFAs) and similar leveraged insurance strategies involve using a life insurance policy as collateral to secure a loan, the proceeds of which are then invested. For more details, visit IFAs: An Accountant’s Guide to Client Suitability and Due Diligence. The tax implications, particularly interest deductibility, require careful analysis.

• Application of ITA 20(1)(c) to IFA Loans: The fundamental principles of paragraph 20(1)(c)—direct use of borrowed funds for an income-earning purpose and a reasonable expectation of income—apply directly to the loan component of an IFA. The loan in an IFA is typically provided by a third-party financial institution, not the insurance company itself (though they may be related entities).
• The “Direct Use” Imperative: Investment Purpose, Not Insurance Policy: This is the most critical aspect for interest deductibility in an IFA context.
  • The borrowed funds obtained via the collateral loan must be traced directly to an independent, eligible income-earning investment. This investment could be publicly traded shares, income-producing mutual funds, bonds, rental properties, or an active business, provided it meets the REOI test.
  • Interest is NOT deductible if the loan proceeds are used, directly or indirectly, to pay the life insurance premiums or to fund the life insurance policy itself. Subparagraph 20(1)(c)(i) explicitly prohibits the deduction of interest on borrowed money used to acquire a life insurance policy. This necessitates a “two-wallet” approach: premiums are paid from the client’s existing capital or income, and the loan proceeds are separately and distinctly invested.
  • The life insurance policy in an IFA serves as collateral for the loan. Its existence, or the fact that it has a cash surrender value, does not, in itself, make the interest on the investment loan deductible. The nature of the collateral is generally irrelevant to the “use of funds” test under 20(1)(c).
• Tracing Requirements in IFA Contexts:
  • Meticulous and demonstrable tracing of the loan proceeds from the lender directly to the specific eligible investment is non-negotiable. This requires careful record-keeping, including bank statements showing the deposit of loan funds and their immediate transfer to purchase the investment.
  • Establishing a separate, dedicated investment account solely for the IFA loan proceeds and the corresponding investments is highly recommended to maintain a clear audit trail and avoid commingling issues.
• CRA Commentary and Positions on IFAs/Leveraged Insurance:
  • Currently, there is no specific CRA Income Tax Folio or Interpretation Bulletin dedicated exclusively to IFAs. Accountants must apply the general principles articulated in Folio S3-F6-C1 and relevant jurisprudence.
  • The CRA has a history of scrutinizing and challenging leveraged insurance arrangements it deems abusive. For example, the “10/8 policies” were specifically targeted and shut down by the enactment of subsection 20(2.01). Similarly, the CRA has issued warnings about Leveraged Insured Annuity (LIA) schemes, particularly those involving offshore elements, deeming them abusive. This history signals a cautious approach from the CRA towards such strategies.
  • Well-structured IFAs, typically using participating whole life insurance where the loan proceeds are genuinely and traceably used to acquire bona fide income-producing investments that meet the REOI test, are generally considered to be compliant with current tax law, based on prevailing administrative practice and the absence of specific adverse rulings for such structures. However, this relies on strict adherence to the rules.
  • The General Anti-Avoidance Rule (GAAR) remains a potential risk, especially for IFA structures that are overly aggressive, lack economic substance beyond the tax benefits, or appear to misuse the provisions of the ITA.
• Deductibility of Life Insurance Premiums (ITA 20(1)(e.2)) in IFA Context:
  • This is a separate and distinct potential deduction from the interest on the investment loan. It pertains to a portion of the life insurance premiums paid by the policyholder.
  • Conditions for Deductibility under 20(1)(e.2):
    • An interest in the life insurance policy must be assigned to a “restricted financial institution” (RFI) in the course of borrowing from that institution.
    • The interest payable on that borrowing must be deductible in computing the taxpayer’s income (i.e., the loan must meet the tests under paragraph 20(1)(c)).
    • The assignment of the policy must be required by the RFI as collateral for the borrowing.
  • Restricted Financial Institution (RFI): Defined in subsection 248(1), an RFI generally includes banks, trust companies, credit unions, and insurance corporations.
  • Deductible Amount: If all conditions are met, the deductible amount under 20(1)(e.2) is the lesser of:
    • The actual premiums payable by the taxpayer under the policy for the year.
    • The Net Cost of Pure Insurance (NCPI) under the policy for the year. This lesser amount is then prorated. Only the portion that can reasonably be considered to relate to the amount owing from time to time during the year under the loan for which the policy is assigned as collateral is deductible. For example, if the policy death benefit is $1,000,000 and the outstanding loan collateralized by it is $400,000 throughout the year, then 40% of the lesser of the premium and NCPI would be potentially deductible.
  • Net Cost of Pure Insurance (NCPI): This represents the pure mortality cost component of the life insurance premium. It is calculated based on prescribed mortality tables and factors, and the insurer typically provides this figure annually. The NCPI often grinds down the Adjusted Cost Basis (ACB) of the policy over time.
  • It is crucial for accountants to understand that the 20(1)(e.2) premium deduction is not automatic in an IFA and is often much less than the full premium paid. Its availability depends on the investment loan interest being deductible in the first place.

The complexity of IFAs arises from the interplay of these distinct elements: the life insurance policy, the collateral loan, the external investment, the potential interest deduction on the loan, and the separate potential (partial) deduction of insurance premiums. Clear separation of funds, meticulous tracing, and a bona fide income-earning purpose for the external investment are paramount.

Table 2: Key Differences: Interest on IFA Loan vs. Life Insurance Premium Deductibility

This table clarifies that these are two distinct potential deductions, each with its own set of rules and calculations, which is essential for accurate advice and compliance in IFA strategies.

6.3. Shareholder Loans and Inter-Corporate Financing

Interest deductibility in the context of loans between shareholders and corporations, or between corporations within a group, presents specific considerations.

• Corporation Borrows to Lend to Shareholder:
  • If a corporation borrows money and then lends those funds to a shareholder for the shareholder’s personal use (e.g., to buy a personal residence or consumer goods), the interest paid by the corporation on its initial borrowing is generally not deductible. This is because the direct use of the borrowed funds by the corporation (i.e., making a personal loan to a shareholder) does not have an income-earning purpose for the corporation. The shareholder, in such cases, may face tax consequences, such as an income inclusion under subsection 15(2) if the loan is not repaid within the specified timeframe, or a deemed interest benefit under subsection 80.4 if the loan is interest-free or at a low interest rate.
  • If the corporation lends the borrowed funds to a shareholder who, in turn, uses those funds for an income-earning purpose (e.g., to invest in their own separate business), the situation is more complex. For the corporation’s interest expense to be deductible, it would typically need to demonstrate an indirect income-earning purpose, such as an expectation of receiving dividends from the shareholder (if the shareholder is also a corporation it controls and the loan enhances that subsidiary’s ability to pay dividends). This can be difficult to establish and would depend heavily on the specific facts.
• Shareholder Borrows to Invest in Corporation:
  • When a shareholder borrows money to invest in a corporation—either by purchasing shares of the corporation or by lending money to the corporation—the interest paid by the shareholder on that borrowing may be deductible by the shareholder. The test is whether the shareholder has a reasonable expectation of earning income from their investment in the corporation (e.g., dividends from the shares or interest income from the loan made to the corporation). This is a common scenario and generally aligns with the standard application of paragraph 20(1)(c).
• Inter-Corporate Financing / Loss Consolidation:
  • The CRA’s Folio S3-F6-C1 (paragraphs 1.71-1.75) addresses arrangements where a profitable corporation in a group borrows funds to invest in preferred shares of a related loss corporation. The loss corporation then uses the proceeds to pay interest on a loan from (or make other payments to) the profitable corporation, or to earn income that can be offset by its losses. The dividends paid on the preferred shares are typically deductible by the profitable corporation under section 112 (inter-corporate dividend deduction).
  • For the profitable corporation’s interest expense on its borrowing to be deductible, the CRA’s key condition is that there should be a “positive spread” between the dividend yield on the preferred shares it acquires and the interest rate on its debt used to acquire those shares. This positive spread helps demonstrate an income-earning purpose for the acquisition of the preferred shares. The transactions must also be legally effective and not considered blatantly artificial.
• Excessive Interest and Financing Expenses Limitation (EIFEL) Rules (ITA 18.2, 18.21):
  • Accountants advising corporations, particularly those in corporate groups or with significant leverage (especially involving non-resident entities), must now also consider the EIFEL rules. These rules, effective for taxation years beginning on or after October 1, 2023, can restrict the deductibility of net interest and financing expenses to a certain percentage of the taxpayer’s “adjusted taxable income” (ATI) – generally 30% for years starting January 1, 2024, with a 40% transitional rate.
  • The EIFEL rules are complex and have their own definitions for “interest and financing expenses” (IFE), “interest and financing revenues” (IFR), and ATI. There are also provisions for “excluded entities” that are not subject to these limitations. These rules can override the deductibility otherwise available under paragraph 20(1)(c) and are a critical new consideration in inter-corporate financing.

7. Non-Qualifying Uses of Borrowed Funds – Red Flags for Accountants

Identifying situations where interest is clearly not deductible is as important as understanding when it is. Accountants must be vigilant for “red flag” uses of borrowed funds.

7.1. Comprehensive List and Explanation

• Registered Plans (RRSPs, TFSAs, RESPs, RDSPs, FHSAs): Interest on money borrowed to make contributions to these types of registered savings plans is generally not deductible. The primary reason is that the income earned and growth within these plans are typically tax-exempt or tax-deferred. Since paragraph 20(1)(c) requires the borrowed money to be used for the purpose of earning taxable income from a business or property, this condition is not met.
• Personal Assets: Loans taken out to acquire assets for personal use or enjoyment do not qualify for interest deduction. Common examples include:
  • Loans for personal-use vehicles.
  • Mortgages on a principal residence (unless a portion of the residence is rented out and meets the conditions for deductibility, as discussed in section 6.1).
  • Loans for vacations, personal consumer goods, or hobbies.
• Vacant Land Limitations (ITA subsection 18(2)):
  • Subsection 18(2) of the ITA imposes significant restrictions on the deductibility of interest and property taxes incurred in connection with vacant land, or land that is held primarily for the purpose of resale or development (i.e., inventory for a land developer).
  • Generally, the deduction for such carrying charges (interest and property taxes) in a particular year is limited to the amount of net income generated from that land in that year. Any excess carrying charges are not deductible against other sources of income.
  • Treatment of Non-Deductible Amounts: The interest and property taxes that are not deductible due to subsection 18(2) are generally added to the cost basis of the land. For land held as inventory, this is mandated by subsection 10(1.1). For land held as capital property, paragraph 53(1)(h) may allow for an addition to the adjusted cost base (ACB). This means the expenses are not entirely lost but are deferred until the land is sold.
  • Exceptions: The restrictions in subsection 18(2) do not apply if:
    • The land can reasonably be considered to have been used in the course of a business carried on in the year by the taxpayer, other than a business whose primary activity is land development.
    • The land is held by certain corporations whose principal business is the leasing, rental, or sale, or the development for lease, rental, or sale, of real property owned by it, to or for arm’s length persons. These corporations may be entitled to a “base level deduction” in addition to net income from the land.
• Direct Acquisition of Life Insurance Policies (Not for Collateralizing a Separate Investment): As stated in subparagraph 20(1)(c)(i), interest on borrowed money used “to acquire a life insurance policy” is explicitly not deductible. This prohibition is critical. It means that if a client borrows money and uses those funds to directly pay premiums for a new life insurance policy, or to purchase an existing policy, the interest on that loan is not deductible. This is distinct from an IFA where the policy is merely collateral for a separate investment loan. There are limited exceptions, such as certain annuity contracts (subparagraph 20(1)(c)(iv)) or interest on policy loans that meet the specific conditions of subsection 20(2.1) (requiring Form T2210 verification).
• Investments Expected to Generate Only Capital Gains: As detailed in section 4.3, if an investment has no reasonable expectation of producing “income” (interest, dividends, rent, etc.) and is held solely for capital appreciation, the interest on borrowed funds used to acquire it is not deductible.
• Paying Overdue Income Taxes: Interest paid on money borrowed to pay outstanding income tax liabilities is a personal expense and not deductible.

7.2. Identifying “Sham” Transactions or Lack of Bona Fide Purpose

Beyond specific prohibited uses, interest deductions can be challenged if the underlying transaction is a “sham” or lacks a bona fide non-tax purpose, even if it appears to technically meet the requirements of paragraph 20(1)(c).

• Sham Doctrine: A sham is a transaction or series of transactions that are disguised to create a false or deceptive legal reality, with the intention of misleading the tax authorities as to the true nature of the arrangement. The Supreme Court of Canada in Stubart Investments Ltd. v. The Queen described a sham as involving an element of deceit. If a transaction is found to be a sham, its purported legal effects are ignored, and taxation is based on the true underlying reality. The CRA faces a high evidentiary bar to prove a sham. The Ludco decision noted that the REOI test applies “absent a sham or window dressing or similar vitiating circumstances,” implying that if a sham exists, it would negate any purported income-earning purpose.
• Lack of Bona Fide (Non-Tax) Purpose / Economic Substance: Even if a transaction is not legally a sham (i.e., its legal form is as intended), it can still be challenged if it lacks any genuine non-tax purpose (business, investment, or family purpose) and is undertaken primarily or solely to obtain a tax benefit. Such transactions may be viewed as artificial or lacking economic substance. While this concept can overlap with the “avoidance transaction” element of the General Anti-Avoidance Rule (GAAR, discussed in Section 9), it can also be relevant in the context of the purpose test in 20(1)(c) itself. For example, in Mark Resources Inc. v. The Queen, an interest deduction was denied where the court found the “real purpose” of a capital contribution to a subsidiary (funded by borrowing) was to absorb the subsidiary’s losses, not to enhance the parent’s income-earning capacity.
• Red Flags for Accountants:
  • Circular Flow of Funds: Money flows in a circle back to the originator with no real change in economic position, other than the creation of a tax deduction.
  • Transactions with No Economic Substance or Risk: Arrangements where the taxpayer is insulated from any real economic risk or has no reasonable prospect of profit apart from the tax benefit.
  • Inflated Values or Unreasonable Terms: Use of non-arm’s length parties to set unrealistic prices or loan terms that would not be found in a commercial setting.
  • Lack of Legitimate Business or Investment Rationale: The transaction makes no sense from a business or investment perspective without considering the tax deduction.
  • Artificial Arrangements Involving Family Members or Related Entities: Using related parties in a series of steps that appear designed solely to achieve a tax outcome not otherwise available.
  • Disguising True Nature of Payments: For example, labeling payments as “interest” when they are, in substance, dividends or some other non-deductible payment.

Accountants should be alert to these red flags. If a proposed leveraged strategy appears overly complex, artificial, or its primary driver seems to be the tax deduction itself rather than a genuine income-earning objective, further scrutiny and caution are warranted.

8. Collateralization and Its Tax Relevance (or Lack Thereof)

When funds are borrowed, lenders typically require collateral to secure the loan against default. While crucial for the lender, the nature of the collateral pledged generally does not dictate the tax deductibility of the interest paid on the loan.

8.1. Review of Common Collateral Types

A wide variety of assets can be used as collateral for loans, including:

• Marketable Securities: Stocks, bonds, mutual funds held in investment accounts.
• Real Estate: Residential homes, rental properties, commercial buildings, vacant land.
• Business Assets: Equipment, inventory, accounts receivable.
• Cash: Cash deposits or GICs.
• Life Insurance Policies: The cash surrender value (CSV) and/or the death benefit of a life insurance policy are commonly used as collateral in leveraged insurance strategies like IFAs.

The choice of collateral is primarily a matter of negotiation between the borrower and the lender and is based on the lender’s assessment of risk and the value and liquidity of the asset being pledged.

8.2. Reinforce for Accountants: Use of Funds is Paramount

It is a fundamental principle of Canadian tax law regarding interest deductibility under paragraph 20(1)(c) that the type of collateral pledged for a loan does not determine the deductibility of the interest on that loan. The paramount test remains the direct use of the borrowed funds for an eligible income-earning purpose.

This means:

• Interest on a loan used to purchase personal-use assets (e.g., a luxury car) is not deductible, even if that loan is secured by a portfolio of income-producing marketable securities. The use of the funds is personal, regardless of the collateral.
• Conversely, interest on a loan used to purchase eligible income-producing investments (e.g., dividend-paying stocks) may be deductible (if all other conditions of 20(1)(c) are met), even if that loan is secured by a personal asset like a principal residence (though using a personal asset as collateral for an investment loan can complicate tracing the use of funds if, for example, a home equity line of credit is used for multiple purposes).

In the specific context of Immediate Financing Arrangements (IFAs), this principle is critical. The life insurance policy’s cash value is used as collateral to secure the investment loan. The deductibility of the interest on this loan depends entirely on whether the proceeds of that loan are directly invested in an asset that has a reasonable expectation of generating taxable income (e.g., a portfolio of dividend-paying stocks or income-producing mutual funds). The fact that a life insurance policy is involved as collateral is irrelevant to the deductibility of the loan interest under paragraph 20(1)(c).

The only instance where the assignment of a life insurance policy as collateral directly impacts a tax deduction related to the arrangement (other than the loan interest itself) is under paragraph 20(1)(e.2). This provision allows for a limited deduction of a portion of the life insurance premiums if the policy is assigned as collateral to a restricted financial institution for a loan whose interest is otherwise deductible. This is a separate deduction for premiums, not for the loan interest, and it has its own specific set of conditions (see Section 6.2).

Accountants must consistently emphasize to clients that the security provided for a loan is a concern for the lender, but for tax purposes, the Canada Revenue Agency (CRA) will focus on the documented use of the actual borrowed funds.

9. Advanced Considerations & Anti-Avoidance Rules

Even if a borrowing arrangement appears to meet the technical requirements of paragraph 20(1)(c), certain advanced considerations and anti-avoidance rules can come into play to deny or restrict interest deductibility. Accountants must be aware of these provisions, particularly when advising on complex or aggressive leveraged strategies.

9.1. Overview of General Anti-Avoidance Rule (GAAR) (ITA 245)

The General Anti-Avoidance Rule (GAAR) in section 245 of the ITA is a broad provision designed to prevent abusive tax avoidance transactions that, while complying with the literal wording of the Act, frustrate its object, spirit, or purpose.

Three-Part Test for GAAR Application: For GAAR to apply, three conditions must be met:

1. Tax Benefit: A transaction or series of transactions must result in a “tax benefit.” A tax benefit is defined broadly to include a reduction, avoidance, or deferral of tax or other amount payable, or an increase in a refund.
2. Avoidance Transaction: The transaction (or one transaction in a series) must be an “avoidance transaction.” A transaction is an avoidance transaction if it results in a tax benefit, unless it is undertaken or arranged primarily for bona fide purposes other than to obtain the tax benefit.
3. Misuse or Abuse: The avoidance transaction must result in a “misuse” of the provisions of the ITA (or Income Tax Regulations, Income Tax Application Rules, a tax treaty, or any other relevant enactment) or an “abuse” having regard to those provisions read as a whole.

Landmark Cases:

• Canada Trustco Mortgage Co. v. Canada (2005 SCC 54): This Supreme Court of Canada case established the analytical framework for applying GAAR. It clarified that the taxpayer bears the onus of refuting the tax benefit and avoidance transaction elements, while the Minister bears the onus of establishing misuse or abuse. The determination of misuse or abuse requires a thorough textual, contextual, and purposive analysis of the relevant legislative provisions.
• Lipson v. Canada (2009 SCC 1): In this case, the Supreme Court applied GAAR to an income-splitting arrangement that involved interest deductions. It demonstrated that even if transactions are legally effective and meet technical requirements, GAAR can apply if the result is an abuse of the Act’s provisions.

Potential Application to Leveraged Investments/Insurance Strategies: GAAR could potentially be applied to leveraged investment or insurance strategies if, despite technically meeting the requirements of paragraph 20(1)(c) for interest deductibility, the overall arrangement is found to be highly artificial, lacking in economic substance beyond the tax benefit, or structured in a way that circumvents the underlying policy intent of the ITA. For example, if an IFA were structured with an investment that had no realistic prospect of generating sufficient income to even notionally service the debt, or if the steps were so convoluted as to obscure a primary tax avoidance motive, GAAR could be a concern.

CRA Guidance: Information Circular IC 88-2, General Anti-Avoidance Rule – Section 245 of the Income Tax Act, and its supplement IC 88-2S1, provide the CRA’s initial administrative guidance on GAAR, although case law has further developed its interpretation. The CRA has a GAAR Committee that reviews proposed applications of the rule to ensure consistency.

Accountants advising on any leveraged strategy, particularly those that appear to generate significant tax benefits through complex steps, must always consider the potential application of GAAR. The “misuse or abuse” test is often the most challenging and fact-dependent aspect.

9.2. Specific Anti-Avoidance: ITA 20(2.01) (“10/8 Policies”), EIFEL (ITA 18.2)

In addition to the GAAR, specific legislative provisions target particular types of arrangements or broad classes of taxpayers to prevent perceived abuses of interest deductibility.

• ITA Subsection 20(2.01) – “10/8 Policies”:
  • Enacted effective for taxation years ending after March 20, 2013, subsection 20(2.01) specifically denies an interest deduction under paragraphs 20(1)(c) or (d) for amounts paid or payable in respect of a “10/8 policy”.
  • A “10/8 policy” is defined in subsection 248(1) of the ITA. Generally, it refers to a life insurance policy (other than an annuity) where an amount is or may become payable under a borrowing or policy loan, and either the return credited to an investment account in respect of the policy is determined by reference to the interest rate on that borrowing/loan (and would not be credited if the borrowing/loan didn’t exist), or the maximum amount of an investment account is determined by reference to the amount of the borrowing/policy loan.
  • This provision was introduced to shut down specific leveraged life insurance arrangements where the policy’s investment return was designed to closely mirror the borrowing costs, effectively creating an interest deduction with minimal economic risk or outlay.
• Excessive Interest and Financing Expenses Limitation (EIFEL) Rules (ITA Section 18.2):
  • The EIFEL rules, found primarily in sections 18.2 and 18.21 of the ITA, are a significant and more recent development, generally applicable to taxation years beginning on or after October 1, 2023.
  • These rules aim to limit the amount of net interest and financing expenses (IFE) that certain corporations and trusts can deduct in computing their income. The deduction is generally capped at a fixed ratio of the taxpayer’s “adjusted taxable income” (ATI). This ratio is 30% for taxation years beginning on or after January 1, 2024 (it was 40% for a transitional period for taxation years beginning on or after October 1, 2023, and before January 1, 2024).
  • The EIFEL rules are part of Canada’s response to the OECD/G20 Base Erosion and Profit Shifting (BEPS) project. They are particularly relevant for multinational enterprises and corporate groups with significant cross-border or related-party financing, but can also apply to purely domestic structures if the thresholds are met.
  • Accountants need to be familiar with the detailed definitions of IFE, interest and financing revenues (IFR), ATI, and the criteria for “excluded entities” (which are not subject to the EIFEL limitation, e.g., certain smaller Canadian-controlled private corporations or groups with low aggregate net IFE).
  • The EIFEL rules can override the interest deductibility otherwise permitted by paragraph 20(1)(c) if the taxpayer is subject to these limitations.

These specific anti-avoidance rules demonstrate Parliament’s willingness to target particular arrangements or create broader limitations where interest deductions are perceived to erode the tax base inappropriately.

9.3. Interest on Money Borrowed for Distributions or Capital Returns (The “Filling the Hole” Concept)

As introduced in Section 3.1, the CRA’s Folio S3-F6-C1 (paragraphs 1.47-1.53) outlines an important exception to the direct use test, commonly referred to as the “filling the hole” concept. This exception allows for the deductibility of interest on money borrowed by a corporation to:

• Redeem its shares.
• Repurchase its shares for cancellation.
• Make a return of capital to its shareholders.
• Pay dividends to its shareholders.

The core principle is that the interest on such borrowed money may be deductible if the funds borrowed are considered to replace capital (either contributed capital or accumulated profits) that was, prior to its distribution, being used by the corporation for eligible income-earning purposes. In essence, if the corporation used its own capital (which could have been distributed) to fund income-generating assets, and then borrows to make that distribution, the borrowed money is effectively now supporting those income-generating assets.

Key Conditions and Limitations:

• Eligible Use of Replaced Capital: The crucial condition is that the contributed capital or accumulated profits being “replaced” by the borrowing must have been employed in activities that would have qualified for interest deductibility had that capital itself been borrowed money. If the original capital was idle or used for non-income-earning purposes, this exception will not apply.
• Measurement of Contributed Capital: Generally, the legal or stated capital for corporate law purposes is used, but other measures might be appropriate. A corporate deficit does not reduce contributed capital for this purpose.
• Measurement of Accumulated Profits: This typically refers to retained earnings on an unconsolidated basis, with investments at cost. It does not track specific shareholdings.
• Application to Partnerships: The same “filling the hole” concept applies when a partnership borrows money to return capital to a partner. The “hole” generally consists of the partner’s contributed capital plus allocated income, less allocated losses and previous distributions (often reflected in the partner’s capital account balance).

This exception is vital for many corporate finance transactions, allowing flexibility in managing capital structure and shareholder distributions without necessarily losing interest deductibility. Accountants must carefully analyze the historical use of the capital being replaced to ensure the conditions for this exception are met.

10. The Accountant’s Pivotal Role in Collaborative Client Service

The complexity of modern financial strategies, particularly those involving leverage and multiple financial products like IFAs, necessitates a collaborative approach among various professional advisors. Accountants, with their specialized tax expertise, play a pivotal and indispensable role in these collaborations, ensuring that strategies are not only effective from an investment or insurance perspective but are also tax-efficient, compliant, and aligned with the client’s overall best interests.

10.1. The Necessity of Inter-Professional Collaboration

Leveraged investment and insurance strategies often sit at the intersection of financial planning, investment management, insurance planning, legal structuring, and tax advice. No single professional typically possesses the depth of expertise across all these domains. Therefore, active collaboration between the client’s accountant, wealth advisor, financial planner, insurance specialist, and potentially legal counsel is crucial.

Such collaboration helps to:

• Develop Holistic Solutions: Ensure that all facets of the client’s financial life are considered, leading to integrated strategies that meet their overall financial, investment, estate, and tax objectives.
• Avoid Siloed Advice: Prevent situations where advice from one professional, given in isolation, might have unintended negative consequences in another area (e.g., an investment strategy that is tax-inefficient, or an insurance structure that complicates estate planning).
• Enhance Client Outcomes: By pooling diverse expertise, the advisory team can often identify more optimal solutions and mitigate potential risks more effectively.
• Manage Complexity: Leveraged strategies, by their nature, are complex. Coordinated advice helps the client understand the various components, risks, and benefits more clearly.

For strategies like IFAs, which involve an insurance policy, a loan, and an investment portfolio, the lack of coordination between the insurance specialist, the lender, the investment advisor, and the accountant can lead to significant errors, such as improper tracing of funds, ineligible investments for interest deductibility, or miscalculation of potential tax deductions.

10.2. Accountant’s Tax Expertise as a Critical Component in Holistic Financial Solutions

While wealth advisors may focus on investment returns and insurance specialists on policy benefits, the accountant’s primary contribution is their deep understanding of the tax implications and compliance requirements associated with any proposed strategy. In the context of leveraged investments and IFAs, the accountant’s role includes:

• Due Diligence on Tax Aspects: Scrutinizing the proposed strategy to assess the validity of claimed interest deductions (under 20(1)(c)) and any other tax benefits (e.g., premium deductibility under 20(1)(e.2) for IFAs). This involves applying the principles discussed throughout this guide regarding purpose, direct use, tracing, REOI, and anti-avoidance rules.
• Ensuring Tax Efficiency and Compliance: Advising on how to structure the borrowing and investment to maximize legitimate tax benefits while adhering strictly to the provisions of the ITA and CRA administrative positions.
• Providing Objective Assessment: Offering an unbiased evaluation of the tax risks and benefits of the strategy, helping the client make an informed decision. This includes considering the potential for CRA audit and the strength of the tax position.
• Complementing Other Advice: The accountant’s tax analysis complements the investment advice from the wealth advisor (e.g., by assessing the after-tax return of a leveraged investment) and the insurance advice from the insurance specialist (e.g., by verifying the conditions for NCPI deductibility in an IFA).

The accountant often serves as a critical checkpoint, validating the tax assumptions underpinning a strategy proposed by other advisors. This role is vital for client protection and ensuring the long-term viability of the financial plan.

10.3. Best Practices for Inter-Professional Communication and Information Sharing

Effective collaboration hinges on clear communication, defined roles, and adherence to professional ethics. Best practices include:

• Establishing Clear Roles and Responsibilities: At the outset of a multi-advisor engagement, it should be clear who is responsible for which aspects of the advice and implementation. For instance, while an insurance specialist might propose an IFA, the accountant would typically advise on the specific requirements for interest and premium deductibility and the necessary documentation. Engagement letters should clearly define the scope of the accountant’s services in such scenarios.
• Client Consent for Information Sharing: The principle of confidentiality is paramount in the accounting profession. Before sharing client information with other advisors, the accountant must obtain explicit client consent, preferably in writing. This consent should specify what information can be shared and for what purpose.
• Regular and Open Communication: Maintaining open lines of communication among all involved advisors is key. This can involve joint client meetings (where appropriate and with client consent), conference calls, and shared written summaries of discussions and agreed-upon actions.
• Respecting Professional Boundaries: Each professional should respect the expertise and boundaries of the others. Accountants should provide tax advice, while deferring to investment advisors on market analysis or insurance specialists on policy specifics, unless there are clear tax implications arising from those areas.
• Ethical Considerations for Referrals: When making or receiving referrals, accountants must ensure their objectivity is not compromised and that the client’s best interests remain the primary consideration. Any referral fees or arrangements should be transparent and comply with professional conduct rules, which generally discourage or regulate compensation for referrals that could impair objectivity.
• Adherence to CPA Code of Professional Conduct: All collaborative efforts must be guided by the fundamental principles of the CPA Code of Professional Conduct: integrity, objectivity, professional competence and due care, confidentiality, and professional behaviour. This includes ensuring that any advice given is based on sufficient knowledge and diligent analysis, and that the accountant does not subordinate their judgment to others.

By fostering a collaborative environment built on trust, clear communication, and ethical conduct, accountants can significantly enhance the quality of advice provided to clients undertaking complex leveraged investment and insurance strategies, ultimately leading to better and more robust financial outcomes.

11. Concluding Summary of Key Principles

The deductibility of interest under paragraph 20(1)(c) of the Income Tax Act is a cornerstone of financing for investment and business purposes in Canada. However, its application is governed by a complex framework of legislative requirements, CRA administrative positions, and evolving jurisprudence. For Canadian accountants advising clients on leveraged strategies, including sophisticated arrangements like Immediate Financing Arrangements, a thorough understanding of these rules is paramount.

Key principles that emerge are:

• The Primacy of Legislative Text: All analysis must begin with the precise wording of paragraph 20(1)(c) and related ITA sections.
• The Direct Use and Purpose Tests: Borrowed funds must be directly traceable to an eligible income-earning use, and there must have been a reasonable expectation of earning taxable income (not capital gains) from that use at the time the investment was made.
• Documentation is Non-Negotiable: The onus is on the taxpayer to substantiate claims with meticulous records.
• CRA Administrative Positions Matter: While not law, CRA Folios like S3-F6-C1 provide critical insight into assessing practices and must be carefully considered.
• Anti-Avoidance Rules are a Constant Consideration: Specific rules (e.g., for 10/8 policies, EIFEL) and the general anti-avoidance rule (GAAR) can override technical compliance if arrangements are deemed abusive or contrary to the Act’s intent.
• Insurance Leveraging Requires Dual Analysis: For IFAs, the deductibility of loan interest (20(1)(c)) is separate from, and a prerequisite for, the potential limited deductibility of insurance premiums (20(1)(e.2)). The collateral nature of the policy does not make loan interest automatically deductible.
• Inter-Professional Collaboration is Essential: The complexity of modern strategies demands a coordinated approach, with the accountant playing a vital role in tax due diligence and compliance.

This guide serves as a technical foundation to aid accountants in their own detailed research and expert application of these principles to specific client circumstances. The dynamic nature of tax law requires ongoing vigilance and professional judgment.

12. Key References for Tax Professionals

To facilitate further independent research and due diligence, this section provides detailed citations for relevant legislative provisions, Canada Revenue Agency (CRA) publications, and pivotal court decisions. Accountants should always consult the most current versions of these primary sources.

12.1. Detailed Citations for Further Independent Research

• Income Tax Act (Canada), R.S.C. 1985, c. 1 (5th Supp.):
  • Paragraph 20(1)(c): Interest on borrowed money and amounts payable for property.
  • Paragraph 20(1)(d): Compound interest.
  • Paragraph 20(1)(e.2): Premiums on life insurance policy assigned as collateral.
  • Subsection 10(1.1): Cost of inventory of land (addition of non-deducted carrying charges).
  • Section 12.2: Income inclusion for interest in annuity contract.
  • Subsection 15(2): Shareholder appropriations/loans.
  • Paragraph 18(1)(a): General limitation – expense must be for purpose of gaining/producing income.
  • Paragraph 18(1)(b): General limitation – no deduction for capital outlay unless expressly permitted.
  • Subsection 18(2): Limitation on deduction of interest and property taxes on certain land.
  • Subsection 18(3.1): Limitation on deduction of construction period soft costs.
  • Section 18.2 & 18.21: Excessive Interest and Financing Expenses Limitation (EIFEL) rules.
  • Subsection 20(2.01): Denial of interest deduction for “10/8 policies”.
  • Subsection 20(3): Deeming rule for refinancing of debt.
  • Section 20.1: Disappearing source rules for interest deductibility.
  • Subsection 80.4: Deemed interest benefit on certain loans to shareholders/employees.
  • Section 245: General Anti-Avoidance Rule (GAAR).
  • Subsection 248(1): Definitions (e.g., “restricted financial institution,” “10/8 policy,” “interest in a life insurance policy”).
• CRA Publications:
  • Income Tax Folio S3-F6-C1, Interest Deductibility (and its Chapter History).
  • Income Tax Folio S3-F1-C1, Shareholder Loans and Debts.
  • Income Tax Folio S3-F1-C2, Deemed Interest Benefit on Shareholder Loans and Debts.
  • (Archived) Interpretation Bulletin IT-533, Interest Deductibility and Related Issues (principles now largely incorporated into Folio S3-F6-C1).
  • (Archived) Interpretation Bulletin IT-153R3, Land Developers – Subdivision and Development Costs and Carrying Charges on Land.
  • (Archived) Interpretation Bulletin IT-309R2, Premiums on Life Insurance Used as Collateral.
  • Information Circular IC 88-2, General Anti-Avoidance Rule – Section 245 of the Income Tax Act (and Supplement IC 88-2S1).
  • Guide T4036, Rental Income.
  • Form T2210, Verification of Policy Loan Interest by the Insurer.
  • CRA Guidance on Excessive Interest and Financing Expenses Limitation (EIFEL) Rules (various web pages and forms).
• Pivotal Court Decisions (Supreme Court of Canada – SCC; Federal Court of Appeal – FCA):
  • Ludco Enterprises Ltd. v. Canada, 2001 SCC 62, [2001] 2 S.C.R. 1082 (REOI test, definition of “income” for 20(1)(c), ancillary purpose).
  • Swirsky v. R., 2014 FCA 36, 2014 DTC 5031 (Application of REOI to shares not paying dividends, objective evidence).
  • Shell Canada Limited v. The Queen, [1999] 3 S.C.R. 622, 99 DTC 5669 (Definition of interest, direct use test).
  • Bronfman Trust v. The Queen, [1987] 1 S.C.R. 32, 87 DTC 5059 (Direct vs. indirect use of borrowed funds).
  • Singleton v. Canada, 2001 SCC 61, [2001] 2 S.C.R. 1046 (Characterizing the use of borrowed funds, tracing).
  • Tennant v. R., [1996] 1 S.C.R. 305, 96 DTC 6121 (Tracing, substituted property).
  • Canada Trustco Mortgage Co. v. Canada, 2005 SCC 54, [2005] 2 S.C.R. 601 (GAAR framework and interpretation).
  • Lipson v. Canada, 2009 SCC 1, [2009] 1 S.C.R. 3 (GAAR application to income splitting and interest deduction strategy).(Other relevant cases are often cited within CRA Folio S3-F6-C1.)

Table 3: Quick Reference: Key ITA Sections & CRA Publications for Interest Deductibility

This reference table provides a quick starting point for accountants to locate the most relevant legislative provision or CRA guidance document for specific interest deductibility issues they encounter.

Promod Sharma (FSA, FCIA) and Jeevan Sharma (CFP) YOUR FAMILY TEAM

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