The rules around interest deductibility are becoming more and more complex. As a business grows and expands their operations to new jurisdictions, and adopts a corporate structure designed to take advantage of certain opportunities related to interest deductibility, the business needs to be careful that the interest amount is in fact deductible in the particular jurisdiction in which it operates.
It is important for all businesses operating in Canada to understand the fundamentals of interest deductibility found in paragraph 20(1)(c) of Canada’s Income Tax Act (the “Act”). Businesses should also consider the thin capitalization rules found in subsections 18(4) to 18(8) and paragraph 12(1)(e.1) of the Act and be aware of the new excessive interest and financing expenses limitation (or “EIFEL”) legislation proposed under section 18.2 of the Act.
This article will explain the fundamentals of interest deductibility under paragraph 20(1)(c). The thin capitalization rules and proposed EIFEL legislation will be discussed in later articles.
What is interest?
Generally, for an amount to be considered interest it must meet the following three criteria:
- it represents compensation for the use of money;
- it is calculated based on a principal sum; and
- it accrues day-to-day.
When is interest deductible? Fundamental limitations
An amount that is considered to be interest will normally be considered to be an outlay on account of capital and not deductible under the general limitation in paragraph 18(1)(b) of the Act. Notwithstanding this general limitation, where the conditions of subsection 20(1)(c) are met, interest can be deductible.
The conditions for the deductibility of interest in subsection 20(1)(c) are as follows:
- The amount is paid in the year or payable in respect of the year under a legal obligation to pay interest;
- Where money is borrowed, the money is used for the purpose of earning income from a business or property (other than borrowed money used to acquire a life insurance policy or property that produces exempt income);
- Where property is acquired, the interest is on the amount payable for the property (e.g., indebtedness assumed as part of the purchase price) and the property is acquired for the purpose of earning income from the property or from a business (other than property that is an interest in a life insurance policy or property that produces exempt income); and
- The amount of interest is reasonable.
Insights
In order for an amount to be payable in respect of the year, there needs to be a legal obligation to pay a sum of money that is absolute and non-contingent. An amount will not be contingent only by reason of the fact that the payment has been deferred until a future date. If a taxpayer has a right to pay a lesser amount of interest, but elects not to do so, then section 143.4 may apply to deny the deduction of the interest claimed in excess of the lesser amount, since the excess is considered to be a contingent amount.
In assessing if the amount of interest is reasonable, the prevailing market rates for debts with similar terms and credit risks should be considered along with any issue premiums. Generally, an interest rate established between two parties dealing at arm’s length will be considered reasonable.
Issues arise when funds are initially used for income producing purposes, but are later used for other purposes, or vice versa. Further, it is not always clear if the particular purpose for which borrowed money is used is for earning income from a business or property, such as when the borrowed funds are used to pay dividends or redeem shares.
Subsequent articles in this interest deductibility series will discuss additional limitations on the deductibility of interest from a Canadian tax perspective. If you have any questions or concerns regarding the deductibility of interest for your corporation, contact a member of the Miller Thomson LLP Corporate Tax team.
