The tax deductibility of interest charged on an investment loan depends on a number of factors, with the Income Tax Act (Canada) providing the framework for this determination. This framework has been interpreted over the years in numerous court cases some of which have shaped the landscape of interest deductibility as we know it today.
The basic criteria
Effectively, the Income Tax Act (Canada) provides three basic criteria in determining whether interest is deductible¹:
- Interest must be paid or payable
- Interest costs must be reasonable, and
- Interest must be paid for gaining or producing income
Interest must be paid or payable
In order for interest to be deductible there must be a legal obligation to pay the interest. In other words, the lender must have the right to enforce payment of principal and interest on a loan.
If the cash method (i.e. an individual) of reporting income is used the interest may be deducted in the year in which it is paid. Conversely, if the accrual method (i.e. a business) of reporting income is used the interest may be deducted in the year in which it becomes payable even it if is not yet paid. However, compound interest is only deductible when it is actually paid.
Interest costs must be reasonable
Interest will be deductible only if it is reasonable in the circumstances. In most cases, the reasonableness requirement will be fulfilled if the interest rate that applies to the borrower is the same as or similar to the market rate of interest that applies to borrowers with similar credit risks in similar circumstances. The Canada Revenue Agency (“CRA”) can deny interest deductions in excess of a reasonable amount.
Interest must be paid for gaining or producing income
In order to be deductible interest must be incurred for the purpose of earning income from a business or property. More specifically, there must be a reasonable expectation of earning income at the time the investment was made with the borrowed funds. It is important to note that capital gains are not considered income. However, in the case of an investment such as mutual funds or securities where the primary objective in connection with the borrowings is capital growth, it would be possible to deduct the interest as long as there is also an expectation to earn income (i.e. interest or dividends).
When these three criteria are met, the interest paid or payable in the year can generally be deducted against income. Investment funds have variable rates of return that could be more or less than the borrowing interest rate. Nonetheless, the full amount of interest should still be deductible even in a year where interest expense exceeds the investment income. (For residents of Quebec, refer to the section “Investment Expense Deductibility: Quebec” on the next page).
Although the three basic criteria outlined provide the basis for interest deductibility, there are a number of additional factors to consider when borrowing money to invest and determining whether the interest on this borrowed money can be deducted.
Interest cannot relate to exempt income², life insurance policies, or deferred income plans
Interest on borrowed money used to earn exempt income, to acquire a life insurance policy or to make a contribution to a deferred income plan such as a Registered Retirement Savings Plan (“RRSP”), Registered Pension Plan (“RPP”), Registered Education Savings Plan (“RESP”), Deferred Profit Savings Plan (“DPSP”), or a Tax-Free Savings Account (“TFSA”) will not be deductible.
Interest incurred to purchase a segregated fund policy
As indicated above, interest on funds used to acquire a life insurance policy will not be deductible. However, the Income Tax Act (Canada) provides an exception where the borrowed money is used to purchase a non-registered segregated fund contract³. Under these circumstances, interest on borrowed funds will be deductible.
Return of capital
Where cash distributions are received from an investment and these amounts include a return of capital, the CRA views this as a portion of the investment being withdrawn and returned to the investor. Where a loan was obtained to acquire the investment and the cash distribution of return of capital is used for personal use, the CRA considers this a reduction in the amount of the loan that is used to earn income from property and therefore there will need to be a proportionate reduction in the amount of loan interest deducted.
Where borrowed money ceases to be used for income-earning purposes because the source of income is gone, interest paid on the borrowed money may continue to be deductible⁴. For example, with respect to the sale of an investment, where the fair market value of the investment has dropped below the adjusted cost base and the proceeds are used to pay down the associated debt, interest may continue to be deductible on the remaining debt despite the asset being disposed of.
The tracing of funds is fundamental to determining interest deductibility. It is the responsibility of the borrower to keep proper records in order to trace the funds to a current eligible use. In situations where it is not possible to trace the borrowed money through to its various uses, the borrower risks losing the interest deduction.
The CRA has indicated that a flexible approach could be allowed to trace the borrowed money to an eligible use where the borrowed money is commingled in an account with cash. However, this approach does not apply to tracing or allocating repayments of money borrowed for various uses under a single line of credit to specific eligible or ineligible uses. In this situation, a constant prorated portion based on initial eligible vs. ineligible uses must be used. Therefore, under current assessing practice, dedicated credit facilities for investment purposes should be used to ensure that any interest incurred will be deductible.
Investment expense deductibility: Quebec
Quebec limits the deductibility of investment expenses incurred by an individual or trust to the amount of investment income earned during the year. The limitation on the deductibility of investment expenses applies to those expenses incurred to earn income from property, other than rental income. Investment expenses incurred to earn active income, such as income from a business or income from the rental of an asset are not subject to this limitation.
It is important to consider the implications when borrowing funds to invest. Each situation should be dealt with on the basis of the particular facts involved to determine if interest is tax deductible. Speak to your advisor to see if this strategy is right for your situation.
Borrowing to invest may be appropriate only for investors with higher risk tolerance. You should be fully aware of the risks and benefits associated with investment loans since losses as well as gains may be magnified. Preferred candidates are those willing to invest for the long term and not averse to increased risk. The value of your investment will vary and is not guaranteed however you must meet your loan and income tax obligations and repay the loan in full. Please ensure you read the terms of your loan agreement and the investment details for important information. The dealer and advisor are responsible for determining the appropriateness of investments for their clients and informing them of the risks associated with borrowing to invest.
1 Paragraph 20(1)(c) of the Income Tax Act (Canada) provides the basic criteria for interest deductibility. 2 Exempt income is defined in subsection 248(1) of the Income Tax Act (Canada). 3 Subsection 20(2.2) of the Income Tax Act (Canada) provides an exception for a non-registered segregated fund policy. 4 Section 20.1 of the Income Tax Act (Canada) provides a rule for the loss of source of income
The commentary in this publication is for general information only and should not be considered investment or tax advice to any party. Individuals should seek the advice of professionals to ensure that any action taken with respect to this information is appropriate to their specific situation. Manulife, Manulife Investment Management, the Stylized M Design, and Manulife Investment Management & Stylized M Design are trademarks of The Manufacturers Life Insurance Company and are used by it, and by its affiliates under license.