TAX

Of Taxing Interest

Before borrowing funds, be sure to determine if the interest and financing charges will be deductible for tax purposes. Individuals and businesses should structure financing to ensure interest is tax deductible. However, be aware that in examining an interest expense deduction, CCRA will review the circumstances surrounding transactions in which the interest arose. As the rules are subject to interpretation by case law, CCRA may challenge and sometimes disallow interest expense in some situations.

The Criteria for Interest Deductibility

 Interest must be an amount paid for the use of borrowed funds, it must be calculated based on the amount borrowed, and it must accrue on a daily basis. Not all amounts shown as interest charges necessarily meet these criteria. However, the interest charged on most commercial loans will meet these tests.

Interest on borrowed funds is deductible for income tax purposes if the money is borrowed pursuant to a legal obligation and the funds are used for an income‑earning purpose. In order for a legal obligation to exist, there must be a contract between lender and borrower providing the terms on which the interest is determined.

Funds are borrowed for an income‑earning purpose if the borrowed money is used for the purpose of earning income from a business or from property. An income‑earning purpose may not be present where, for example, money is borrowed at a rate of 10% to invest in Treasury bills with a return of 4%. In this case, only a portion of the interest would likely be considered incurred for an income‑earning purpose, i.e., probably only 4% of the interest would be deductible as the 10% interest rate exceeds the investment rate.

Funds are not considered to have been borrowed for an income‑producing purpose where the only return expected on the purchased property will be in the form of a capital gain. Capital gains by their nature are not income amounts even though they are included in income for tax purposes. If the borrowed funds are used to buy an insurance policy, the interest incurred is also not deductible.

The amount of interest you may deduct in a year is the amount paid or payable in the year depending on whether you are using the accrual or cash basis method of accounting.

Maximize Interest Deductibility

Borrowing should always be planned to maximize interest deductibility. As a winning strategy, an individual or business should:

• Borrow for the purpose of gaining or producing income since the interest is deductible

• Use other sources of funds or excess working capital to reduce or repay loans for which the interest is not deductible.

Borrowing to Repay a Loan

Assume for a moment that your business has a loan with Lending

Co. A on which the interest is deductible and you decide to borrow from Lending Co. B to pay down the loan. The interest on funds borrowed from Lending Co. B is an allowable deduction under the Income Tax Act. However, if you borrow funds in excess of the amount owing to Lending Co. A., to deduct interest expense on the additional loan, you would have to establish that the additional borrowed funds were also used for the purpose of earning income.

The Source of Income Disappears

In the past, if a downturn forced the sale of an investment asset or the closure of a business, the interest on any outstanding loan ceased to be deductible. Where those events occur after 1993, amendments provide that during the period the loan remains outstanding, the interest continues to be deductible even after the business is discontinued or the property is disposed of, or becomes worthless. These rules do not apply to investment assets, which are real property or depreciable property.

The amount of the remaining outstanding loan upon which deductible interest will continue to be allowed is reduced by the amount of proceeds received on the liquidation of the investment. If the loan balance is not reduced by the proceeds, a calculation must be made of the amount of deductible interest.

Insurance Loans

Policyholders often borrow money from an insurance policy. In order for the interest paid on the policy loan not to be added to the adjusted cost base of the insurance policy, you must have the insurer complete Form T2010 Verification of

Policy Loan Interest by the Insurer no later than the date that your income tax return is due for the year. If this is done, the amount is considered to be interest for income tax purposes and is deductible if the other criteria outlined above are met.

Before Borrowing

Review your corporate and personal debt situation with your chartered accountant. Now may be the time to consider restructuring the debt and income‑producing assets to obtain a greater deduction for interest being paid.

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