Canada: 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:

  1. The amount of interest must be paid in the year or be payable in the year in which it is sought to be deducted;
  2. The amount of interest must be paid pursuant to a legal obligation to pay interest on borrowed money;
  3. The borrowed money must be used for the purpose of earning non-exempt income from a business or property; and
  4. 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 not determinative. The TDL Case considered and elaborated on the meaning of the purpose test in subparagraph 20(1)(c)(i) as pronounced in Ludco.

B. The TDL Case

This case dealt with the deductibility of interest on borrowed money used by a Canadian resident corporation to acquire additional common shares of its wholly-owned US subsidiary. The facts of this case can be summarized as follows:

  1. On March 18, 2002, Wendy's International Inc. ("Wendy's), a non-resident of Canada, made a loan to its US Subsidiary Delcan Inc. ("Delcan") at an interest rate of  7%;
  2. On the same day, Delcan loaned the full amount to the appellant ("TDL"), a Nova Scotia unlimited liability company at an interest rate of 7.125% (and subsequently assigned the loan to another affiliate in the group);
  3. On March 26, 2002, TDL used the borrowed money to subscribe for additional common shares in its already wholly-owned US subsidiary, Tim Donuts US Limited ("Tim's US");
  4. On March 27, 2002, Tim's US used the subscription proceeds paid by TDL and made  an interest-free loan to Wendy's for a promissory note (the "Note"). The facts indicate that the Note was intended to be interest-bearing but it was decided that the loan would proceed on a non-interest basis until certain tax concerns were properly addressed.  
  5. In June 2002, Tim's US assigned the Note to its wholly-owned US subsidiary, Buzz Co. in exchange for common shares of Buzz Co.  Buzz Co. then issued a demand for payment to Wendy's, which was repaid by issuing a new promissory note to Buzz Co. at an interest rate of 4.75%.

TDL claimed the interest deduction in respect of the borrowed money from Delcan pursuant to subparagraph 20(1)(c)(i). However, the deduction was denied by the Minister of National Revenue ("Minister") during the period of time when Tim's US loaned the money to Wendy's on an interest-free basis on the basis that TDL did not have a purpose of earning income from investing in common shares of Tim's US.

The issue at the heart of this case was whether the money borrowed by TDL was used for the purpose of earning income from the common shares that TDL acquired in Tim's US. The TCC was quick to conclude that the "use" test of the borrowed funds was satisfied as it was unambiguous that the funds were used to acquire common shares of Tim's US. The TCC then turned to examine whether TDL had an income earning "purpose" with respect to its investment in the common shares of Tim's US.

The TCC referred to the Ludco decision, particularly, the statement that  "the requisite test to determine the purpose for interest deductibility under s. 20(1)(c)(i) is whether, considering all the circumstances, the taxpayer had a reasonable expectation of income at the time the investment was made."4 [emphasis added] In the TDL Case, the TCC interpreted the phrase "all circumstances must be considered" broadly to mean that in determining the purpose test, the use of the funds by the subsidiary (i.e., Tim's US) should be examined. In particular, it stated:

The language of "all circumstances" is very broad. In my view, such language cannot be consistent with any position that would suggest the use of the funds by the subsidiary or other members of the group and cannot be considered nor that any series of transactions related to the direct investment cannot be considered...5

Based on all of the circumstances of the case, the TCC concluded that TDL did not have a reasonable expectation to earn income at the time of the acquisition of the Tim's US shares for reasons that included but were not limited to the following:

  • TDL was a loss company which had no history of past dividends and had historically not been in a financial position to pay any immediate or short term dividends.
  • The corporate group had a policy of no return on investments (i.e., dividends) until all capital expenditures were funded and Tim's US had a 10-year plan which projected zero dividends to be paid.
  • There was no mention of any potential dividends to be paid in any of the documents examined by the court.
  • As TDL was the sole-shareholder prior to the acquisition of additional shares, the TCC found that any quantitative earning capacity it had did not change as a result of its new investment unless it was demonstrated that the new investment could be expected to create or increase the chances for dividends or increase the value of Tim's US shares, which the TCC found was not the case based on the facts.
  • There was no credible evidence that any portion of the funds would be used or intended to be used for any other purpose other than to loan money to Wendy's on an interest free basis.

The TDL Case has been appealed. Subject to the decision of the Federal Court of Appeal (the "FCA"), this case significantly broadens the scope of the purpose test by opening the door to an examination of the indirect use of the borrowed funds and not limiting the analysis to the circumstances surrounding the direct investment. Prior to this case, it was widely accepted that the purpose test would be satisfied where borrowed funds are used to acquire common shares, provided that the issuer did not have a policy against paying dividends because common shares have the potential to earn unlimited dividends (i.e., income from property). In this respect, the analysis did not need to extend to how the issuer of the common shares used the borrowed money. Interestingly, this view seems to be supported by the CRA in the Folio, which was coincidentally released on the same day as the TDL Case, and provided that: "if a corporation is silent with respect to its dividend policy, or its policy is that dividends will be paid when operational circumstances permit, the purpose test will likely be met."6 If the TDL Case is upheld on this issue, it will add another layer of examination to any subparagraph 20(1)(c)(i) analysis by requiring a factual determination of the manner in which the issuer used the borrowed funds and whether such use supports the purpose test analysis. The FCA's views on this point will be heavily anticipated.

An interesting point to note is the TCC's comments in the TDL Case with respect to its interpretation of the term "income" in the context of subparagraph 20(1)(c)(i). The TCC cited Ludco for the proposition that income "refers to income generally, that is an amount that would come into income for taxation purposes not just net income".7 The TCC in the TDL Case suggested that this statement could be interpreted to extend to capital gains. This interpretation would seem to allow taxpayers to invest in non-dividend paying shares if there is a reasonable expectation of earning capital gains and would run contrary to the CRA's long-standing position that interest is only deductible where borrowed money is used to acquire dividend-paying shares. If this view is upheld by the FCA, it will be highly beneficial for taxpayers as it will expand the application of subparagraph 20(1)(c)(i) to investments that may not have been previously eligible for interest deductions.

C. Interest Deductibility Folio

The Folio replaced and canceled CRA's Interpretation Bulletin IT-533, Interest Deductibility and Related Issues. It should be noted that the CRA accepted public comments on this draft Folio until June 6, 2015 for consideration.  As such, it is possible that the Folio may be further revised. While the Folio reflects many of the positions previously found in IT-533, it also contains a number of additions. Below is a non-exhaustive list of relevant additions in the Folio:

  • It acknowledges that Ludco indicates that an ancillary purpose to produce income is sufficient to satisfy the purpose test.
  • With respect to the deductibility of interest in the context of loss consolidation transactions, CRA takes the view that there must be a positive spread between the dividend yield on the preferred shares acquired with the borrowed money and the interest rate on the debt.
  • It adds a statement regarding CRA's long standing policy that where a taxpayer borrows to buy common shares and subsequently receives a distribution of paid-up capital on such shares, the interest on the borrowed money becomes non-deductible unless the proceeds continue to be used for an eligible purpose for purposes of subparagraph 20(1)(c)(i).
  • It adds a statement that "where accrued interest is added to the outstanding principal amount of an existing loan resulting in a new obligation or novation, an interest payment will not be considered to have been made".
  • It adds a statement that interest deductibility is acceptable on currently deductible accounts payable to service providers.
  • Generally where borrowed funds are commingled in a single account (i.e., borrowed funds are placed in one bank account some of which are used for interest deductible purposes and some of which are not), the CRA adopts a flexible approach whereby taxpayers can allocate a portion of the funds in such bank account to eligible use, and interest on such amounts would be deductible. The Folio provides that a flexible approach cannot be applied to the repayment of borrowed money when a single borrowing account (such as a line of credit, mortgage or loan) is used for eligible and ineligible purposes. The CRA takes the view that any repayment of the principal portion of a borrowing would reduce the portions of the line of credit, mortgage or loan that are used for both eligible and ineligible purposes (i.e., the repayment cannot be used solely to reduce the borrowing in respect of non-eligible use).

Interest deductibility is an issue that requires close analysis to ensure compliance with the ITA. The continued evolution and development of this area of the law makes it all the more necessary to obtain tax advice well in advance of structuring any financing arrangements.


1. The Queen v. Phyllis Barbara Bronfman Trust, 87 DTC 5059.

2. 2015 TCC 60.

3. 2001 SCC 62.

4. Ibid, at paragraph 54.

5. Supra note 2, at paragraph 26.

6. See paragraph 1.70 of the Folio.

7. Supra note 3, at paragraph 61.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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