Canada: Interest deductibility tests: Canada versus the US
01 August 2014
Posted by: Author: Clara Pham
Authors: Clara Pham and Frank Simone (KPMG LLP)
Suppose that taxpayer A makes a loan to taxpayer B; is the interest on the loan deductible for tax purposes? The answer depends on whether deductibility is tested under Canadian tax rules or US tax rules.
The two relevant Canadian tax provisions for determining interest deductibility are subparagraphs 20(1)(c)(i) and (ii). Subparagraph 20(1)(c)(i) permits a taxpayer to deduct amounts payable in the year as interest on borrowed money that is used for the purpose of earning income from a business or property. Subparagraph 20(1)(c)(ii) allows the deduction of interest on an amount payable for property acquired for the purpose of gaining or producing income from the property or from a business.
Generally, the income-earning purpose tests in both subparagraphs have been interpreted to mean that the borrowed funds must be directly and currently traced to an income-earning use (Interpretation Bulletin IT-533, "Interest Deductibility and Related Issues,” October 31, 2003; Bronfman Trust v. The Queen,  1 SCR 32). Thus, taxpayers A and B should be able to deduct the interest expense generally for Canadian tax purposes if the loan was used to fund the purchase of machinery or as working capital to be used in taxpayer B’s business. The interest could also be deductible if taxpayer B used the loan to purchase shares of taxpayer C. However, the entire interest expense could be denied (subject to subsection 20.1(1)) if taxpayer B disposed of all its business assets and did not redeploy the funds in an eligible use, because the debt can no longer be currently traced to a business. Interest deductibility could also be lost if taxpayer C never has paid and never will pay dividends to its shareholders because taxpayer B did not have a reasonable expectation of earning income at the time it made the investment in taxpayer C (Swirsky v. Canada, 2014 FCA 36).
Under the equivalent US federal income tax rules, including section 163 of the Internal Revenue Code, interest deductibility in the corporate context turns not on the use of the funds but rather on a mainly substantive assessment of the characterization of the instrument as debt or equity. The case law on this issue focuses on the intention of the parties to create a debtor-creditor relationship and the ability of the debtor to repay the debt (Estate of Mixon v. United States, 464 F. 2d 394 (5th Cir. 1972) and In Re Lane, 742 F. 2d 1311 (11th Cir. 1984)). Therefore, even if taxpayer B sells all of its business assets or if taxpayer C does not pay dividends, the interest could nonetheless be deductible (subject to specific limitations and anti-avoidance provisions in the Code).
That conclusion will change, however, if the loan is not respected as indebtedness. This outcome could occur if taxpayer B is overleveraged at the time the loan was extended; if the terms of the debt were not commercially reasonable; or if taxpayer A did not enforce the terms of the debt instrument over the term of the loan (for example, if interest and principal payments were not made by taxpayer B when prescribed in the agreement, and taxpayer A did not enforce its creditor remedies). In these instances, the instrument could be recharacterized as equity and any amounts paid thereon might not be treated as interest that is deductible—a result that may have unintended consequences for both the payer and the recipient.
This article first appeared on ctf.ca.