Calgary Accounting

Year end is the right time to review lines of credit, demand loans and other borrowings to separate tax-deductible interest from that which is not deductible. In addition, December is a good time for a taxpayer who has lent money to his or her spouse to compute the spouse’s interest payable. A review of the interest deductibility rules, therefore, is in order for taxpayers and their advisors.

Paragraph 20(1)(c) of the Income Tax Act allows deductibility of interest on loans taken to pursue certain profit-seeking activities. It allows a taxpayer to deduct interest if it is:

• paid or payable in the year;

• arises from a legal obligation;

• payable on borrowed money that is used for the purpose of earning income (other than exempt income) from a business or property; and

• reasonable in amount.

The deductibility of interest on money borrowed to earn income from a business or property has generated a substantial amount of litigation over the years. Lipson v Canada (2009) is an example.

According to the Act, the deductibility of interest depends upon the intention of the borrower at the time that he or she invests the funds. The investment must have the potential to earn gross income, not net income. Thus, it is not necessary to make a taxable profit in order to deduct the interest expense.

In Lipson, which has been described as “the most important tax decision in the last 70 years” by a leading academic in the field, Vern Krishna, the Supreme Court of Canada was divided on whether a taxpayer could validly deduct his home mortgage interest.

In Lipson, the wife borrowed $562,500 from the bank to buy shares, at market value, in her husband’s company. The next day she and her husband took out a joint mortgage on their home from the same bank for the same amount. They immediately used the mortgage money to repay the wife’s loan for the shares. Relying on the spousal attribution rules in the Income Tax Act, the husband, being the higher-income earner, subsequently deducted the mortgage interest from his personal income taxes and reported the taxable dividends on the shares as income. By a majority of four to three, the Court held that although each transaction viewed in isolation complied with the Act, their combined result frustrated the purpose of the spousal attribution rules and violated the General Anti-Avoidance Rules (GAAR).

In Singleton v Canada (1999), a case with similar facts, a lawyer with cash savings borrowed an amount equal to his savings to invest in the capital of his law firm. He then used the savings to buy a home. Under these circumstances, the court held that the interest on his loan was deductible. The minority in Lipson felt that these same sorts of transactions “with a spousal twist” were also in conformity with the Act. The dissenters argued: “There is nothing in the Act to discourage the transfer of property at fair market value between spouses. Indeed, by allowing a spouse to transfer property to the other spouse at the transferor’s adjusted cost base, Parliament intended to make such interspousal transfers attractive.” Furthermore, “the outcome was not so much an abuse ‘of the specific provisions’ [an essential element in order for the GAAR to apply] as it was a fulfilment of them.”

Since the court was so divided, it is unlikely that Lipson is the final word on interest deductibility in interspousal transfers. In the meantime, you can benefit from the following tips in structuring your debts so as to maximize your chances of successfully deducting the interest:

• interest is deductible only if the lender has legal rights to enforce payment of the amounts due (Para 18(1)(e).

• the intention must be to earn income from business or property — not from capital gains.

• Interest expense is not deductible if the taxpayer uses the funds to earn income that is exempt or to acquire a life insurance policy (Para 20(1)(c).