Interest Deductibility: Recent Developments

The Canadian tax regime generally allows for the deductibility of interest on borrowed money or indebtedness incurred for the purposes of earning income from a business or property. The Supreme Court of Canada (the "SCC") has stated that the purpose of this rule is to "encourage the accumulation of capital which would produce taxable income".1 The rule can be found in paragraph 20(1)(c) of the Income Tax Act (Canada) (the "ITA"), and while it is relatively straightforward in principle, its application can be complex as evidenced by the multitude of judicial decisions which have interpreted and applied it.

This article provides an update of recent developments in the area of interest deductibility. In particular, it discusses the recent Tax Court of Canada (the "TCC") decision of The TDL Group Co. v. Her Majesty The Queen2 (the "TDL Case") and its impact on the interpretation of subparagraph 20(1)(c)(i) of the ITA. The article also highlights additions in Canada Revenue Agency's ("CRA") recently released draft Income Tax Folio S3-F6-C1 (the "Folio") which deals with CRA's administrative views on interest deductibility.

A. Background

In general terms, subparagraph 20(1)(c)(i) of the ITA provides four conditions that must be satisfied in order for interest on borrowed money to be deductible:

The amount of interest must be paid in the year or be payable in the year in which it is sought to be deducted; The amount of interest must be paid pursuant to a legal obligation to pay interest on borrowed money; The borrowed money must be used for the purpose of earning non-exempt income from a business or property; and The amount of interest must be reasonable. The third condition touches upon two important tests in 20(1)(c)(i): the use and the purpose of the borrowed money.

Canadian courts have generally held that the use of borrowed money must be currently and directly traced to an income earning purpose from a business or property, subject to certain exceptional circumstances which may allow for an examination of the indirect use. Secondly, the purpose of the borrowed money at the time of the investment must be to earn income from a business or property. In the SCC decision of Ludco Enterprises Ltd. et al. v. The Queen3 ("Ludco"), the Court provided that the purpose test seeks to determine whether any purpose of the taxpayer (i.e., be it the main or ancillary purpose) was to earn income and that the test contains both objective and subjective components. The objective component requires a review of "all the circumstances" to determine the existence of a reasonable expectation to earn income. The subjective component requires a review of the subjective purpose of the taxpayer, which is relevant to the objective analysis but is...