Interest tax deductible — but it can catch the CRA’s eye

The ability to write off interest expense as a deduction on your tax return can substantially decrease your after-tax cost of borrowing. Whether interest is tax deductible, however, can sometimes lead to a dispute with the Canada Revenue Agency, as we saw in a recent decision of the Tax Court of Canada, released earlier this month.

The case involved an Alberta taxpayer who owns and operates two commercial properties which he bought in 2003 and 2008 with specific plans in mind for each one. However, things did not unfold as expected.

The case

The taxpayer owns two properties, the first consisting of a 15,000-squarefoot commercial space in Edmonton which was purchased in 2003. The taxpayer spent over $1.4 million renovating the property, after a planned sale fell through in 2008, and the prospective purchaser caused extensive damage to the building. He did so on the advice of realtors, “to salvage the building and improve its marketability by renovating and condominiumizing it.” The improvements were completed in 2009 and brought the property up to current building codes, increasing the rental rate from $8 to $15 per square foot.

The second property, an acre of land in a small town northwest of Edmonton, was purchased in 2008 with the intention to build and was intended to be a partnership with his close friend. However, his friend passed away suddenly and the taxpayer had to continue on his own. At the time of his death, the taxpayer’s friend had not contributed any financing to the property. There was already a lease commitment from an oil and gas company for the property so the taxpayer had to complete the construction on time. Ultimately, a 3,750-square-foot pre-engineered steel building was constructed on the property, which now sits empty because its tenant went bankrupt.

To help pay for the unexpected renovation of the first property, the taxpayer used his personal savings, cashed in all of his stocks and RRSPs, and borrowed about $120,000 from family and friends. The loans from family and friends were interest-free and not recorded in writing. He then obtained personal lines of credit and used this money to repay his family and friends, as well as to fund the ongoing renovation of both properties. He testified that he proceeded this way because it would not delay the renovation and construction projects. In addition, the first property was empty and not in rentable condition such that it was not valuable enough to use as security against a bank loan.

Lines of credit

It was the interest paid on three personal lines of credit (LOC) that gave rise to the dispute with the CRA. LOC #1, with an unsecured credit limit of $68,800, was obtained in 2004, LOC #2, with a credit limit of $262,500 was obtained in 2006, and LOC #3, with a credit limit of $128,500, was obtained in 2010. The LOC #2 and #3 were secured against his personal residence.

From 2013 to 2015, the amount borrowed on each LOC stayed at the maximum limits for each and minimum monthly payments were made with equivalent cash advances subsequently withdrawn. The taxpayer explained that in those years, he would have to make a payment to one LOC and then withdraw the money to pay other bills. At one point, he carried six LOCs but has since paid several of them off.

The issue before the court was whether the taxpayer could deduct the interest expense ($17,715, $18,416, and $17,192 for the 2013, 2014, and 2015 tax years, respectively) arising from the three LOCs. The answer to the question turns on whether he used the private loans and the LOCs to earn income from a business or property in those years.

The law

Under the Income Tax Act, if you borrow money for the purpose of earning investment or business income, the interest you pay on that debt is generally tax deductible. Previously, the Supreme Court of Canada articulated the four requirements that must be met in order for interest to be tax deductible. Firstly, the amount must be paid (or payable) in the year. Second, it must be paid pursuant to a legal obligation to pay interest on borrowed money. In addition, the borrowed money must be used for the purpose of earning income from a business or property and, finally, the amount of interest paid must be reasonable.

There is also a special deeming rule in the Act which states that if a taxpayer uses borrowed money to repay money previously borrowed, the borrowed money is deemed to be used for the same purpose as the previously borrowed money. This rule generally allows a taxpayer to continue to deduct interest on a loan used to refinance another loan, where the interest on the original loan was tax deductible.

IT WAS THE INTEREST PAID ON THREE PERSONAL LINES OF CREDIT (LOC) THAT GAVE RISE TO THE DISPUTE WITH

THE CRA.

Analysis

The judge found the taxpayer to be “very credible” and accepted his explanation that the money borrowed from the three LOCs helped pay for the costs of renovating and constructing the two properties and to repay his family and friends for money he borrowed to urgently finance the renovation of the first property.

The judge found that the fact that the funds in the various lines of credit were commingled among the three purposes of repaying his private loans, the renovation project, and the construction project was “insignificant because all are eligible uses in the circumstances.”

While the taxpayer’s record-keeping was “imperfect,” the judge was able to review copies of the three LOC agreements along with the monthly account statements for the three years under review to substantiate the fact that the three LOCs remained at their maximum credit limits. She concluded that since the LOCs were used to repay loans from family and friends and that the purpose of those loans was to earn business income, the special deeming rule in the Act considered that the LOCs to have been used for the same purpose as the original loans, and thus the interest was, indeed, properly tax deductible.