Deducting investment loan interest

Managing the tax aspect of borrowing to invest[1]

Investors may invest their own money, and may also borrow to put more money to work. Also known as ‘leveraged investing’, the presumed intention is to increase market exposure and multiply potential investment returns. Depending on market movement at a given time, that multiplication can work either for or against an investor, which is why such decisions should be discussed with a qualified investment advisor.

That advisor-investor discussion should focus first on how a planned strategy fits that individual’s financial circumstances, including objective risk tolerance and subjective comfort with risk. Attention can then turn to the tax issues, and in particular the rules for claiming interest expense as a tax deduction.

Requirements for deductibility

Interestingly, interest is not defined in the Income Tax Act (ITA), so case law has filled in that gap. Generally, it is compensation paid for the use of a principal sum, calculated on a day-to-day accrual basis. Less technically, it’s what a borrower pays for the use of a lender’s money.

When it comes to deductibility, the ITA deals with that in a roundabout way, first denying deductibility for interest in paragraph 18(1)(b), then setting out conditions to allow for exceptions to that denial in paragraph 20(1)(c).
The four key requirements follow.

1. Paid or payable in the year

Most taxpayers will deduct the amount of interest that accrues in relation to a year, but if a taxpayer uses the cash method of accounting then it is the amount actually paid in a year that may be deducted.

2. Legal obligation on borrower

A borrower records interest as an expense once all conditions for the legal obligation to make the payment have been met. If the payment is contingent on a future event then a deduction cannot be taken until that contingency has been fulfilled.

3. For the purpose of earning income from a business or property

The borrower must have a reasonable expectation that the investment will earn income, even if the income may be less than the interest expense. This requirement will be met if the investment is capable of earning income (whether or not there is income in a given year), but not if the investment is only able to produce capital gains.

4. Amount of interest must be reasonable

The reasonableness of the interest charge is determined with reference to prevailing market rates for debts with similar terms and credit risks. In an arm’s length transaction with a financial institution, the reasonableness will usually be obvious (though not guaranteed) by the commercial practices and documentation employed. In other cases a closer look at the circumstances may be required.

Application to marketable securities

Per the third requirement above, an investment may be made in either a business or property. Property may be either real property (more commonly known as real estate) or moveable property. Marketable securities fall into that last category of property.

Individual securities or mutual funds

Marketable securities include instruments like stocks and bonds, and may be either individually-owned or held as part of a pooled investment structure. Common pooled structures include mutual funds, exchanged-traded funds (ETFs), and segregated funds issued by insurance companies.

Qualifying account type: Non-registered

For interest to be deductible, the expected income must be taxable. Accordingly, the relevant type of investment account where the securities are purchased and held is a taxable account, also known as an open, cash or non-registered account.

Registered accounts

Interest is not deductible when a loan is used to earn income that is tax-exempt. Thus, no deduction is allowed when borrowing to invest in registered plans such as a registered retirement savings plan (RRSP), tax-free savings account (TFSA), registered education savings plan (RESP), or registered disability savings plan (RDSP).

This does not prevent a person from borrowing to fund such accounts, for example the practice of using RRSP loans, but rather it is a prohibition on deductibility of the associated interest when used in this manner.

Current use, and replacement property

It is the current use of the borrowed money that determines deductibility. On initial borrowing, the initial use and current use will be the same. Later transactions with the property can affect deductibility, depending on the value of the invested property, the outstanding loan balance, and how the proceeds are reallocated. *

When an original investment is disposed for an amount equal to the amount borrowed:

- If the entire proceeds are moved to one or more qualifying investments, then all interest charges will continue to be deductible.
- If the proceeds are divided among qualifying and non-qualifying property, deductibility will be limited to the proportion of the proceeds allocated to the qualifying investments.

If that original investment has grown in value relative to the amount borrowed, the investor has some flexibility in how the borrowing is linked to the replacement property.

- The investor may still choose to allocate the borrowing proportionately among the new properties.
- However, it may be advantageous to make a disproportionate allocation. Assume an original borrowed/ invested amount of $100,000 had grown to $150,000 when disposed, with the proceeds used to acquire qualifying investment “QI” for $130,000 and non-qualifying property “NQ” for $20,000. The investor may choose that the current use of the borrowed money is entirely for QI since its value exceeds the outstanding loan balance, allowing for continuing full deductibility.

Where the value of the replacement properties is less than the outstanding loan balance, a pro-rata allocation is required. Assume the original $100,000 borrowed/invested in the above example is disposed for $80,000, with $60,000 used to acquire QI and $20,000 used for NQ. The current use of the borrowed money would be $75,000 in a qualifying investment ($60,000/$80,000 x $100,000), limiting the deduction to 75% of the interest charges.

* In these examples, the gross proceeds are being used for the replacement properties, with any tax on capital gains (or recovered tax on capital losses) managed through an outside source/account. Alternatively, tax could be managed from within the investment, with the net proceeds reinvested. The numerical illustrations would be more complicated under the latter approach, but the investor’s net tax cost is the same either way, and the principles being discussed remain the same.

Drawing down investments

As with any investment held over several years, realized income will be distributed and taxed to the investor annually. Assuming growth over the long term, the holding at any given future date will be a combination of the invested capital – in this case originating from borrowed money – and the undistributed growth of the investment, which for tax purposes is the unrealized capital gain.

There are two tax issues that arise on disposition of the investment:

- A capital gain (or capital loss) will be triggered on a disposition. Though the tax calculation is no different whether the original money was borrowed or was the investor’s own source, it helps to first isolate and resolve the effect of the disposition, to then fully focus on what happens with interest deductibility thereafter.
- It is the actions taken after the disposition that affect interest deductibility. This is the application of the ‘current use’ principles above, illustrated below according to the way in which the drawdown occurs.

Lump sum disposition

If an investor disposes of an investment in full, tax will be due on the realization of the entire capital gain in that one year. The remaining amount received will be a non-taxable return of capital (ROC). (See our article “Capital gains taxation – Deferred, preferred and more” for a more detailed discussion of the associated tax issues.)

If the investor reallocates the proceeds from disposition of an investment to other property, the deductibility of any continuing interest charges will be governed by the principles outlined earlier. On the other hand, if the investor decides to use a portion of the proceeds to retire the outstanding loan balance, there will be no further interest charges and therefore no deductibility issues to contend with.

Periodic or systematic withdrawals

An investor may instead decide to draw the money out periodically as desired, or on a regular routine through a systematic withdrawal plan (SWP). Either way, each withdrawal will be a combination of ROC and realized capital gains. (See our article “Systematic withdrawal plans” for a more detailed discussion of the associated tax issues.)

Often the plan for such accounts is to allow them to accumulate undisturbed for a period, then to use a monthly or annual SWP to supplement personal finances later in life. Whether used to acquire capital property for personal use or to spend on personal expenses, this is effectively a reallocation of the withdrawn amount toward non-income earning purposes. As such, a portion of the continuing interest payments will no longer be deductible.

In the simplest case where there have been no prior withdrawals and no further contributions beyond the original investment, the non-deductible portion will roughly equal the ROC component of the withdrawal divided by the outstanding loan. (A qualified tax professional should be consulted to verify the facts and perform the calculation.) However, the investor may preserve deductibility on future interest charges by paying down the loan by the corresponding amount, such that the remaining debt continues to be linked to an income earning purpose.

ROC on ‘t-series’ mutual fund distributions

Some mutual fund managers allow investors to receive a fixed annual distribution out of their mutual fund holdings using a t-series distribution. The “t” refers to tax, and specifically that such distributions may enable the deferral of tax on unrealized capital gains within the mutual fund.

The manager allows the investor to choose a single digit distribution percentage, usually in the 4% to 6% range. The rate is applied to the investment balance at the beginning of the year to arrive at equal monthly payments made over the course of the year. At the end of the year, the manager tallies up the fund’s performance and reports what portion of those payments were distributions of realized income, with the remainder being ROC.
For some mutual funds there may be no realized income, such that the entire year’s payments may be ROC.

Being a return of the investor’s own capital, the ROC portion is tax-free. Though appealing in the current year, the trade-off is that the investor’s adjusted cost base (ACB) is reduced by the amount of the ROC distribution. This means that a greater proportion of each future investor withdrawal will be taxable, as the realized capital gain part of a withdrawal is the difference between the fair market value of the withdrawal and its proportionate ACB.

As with a periodic withdrawal or SWP discussed above, the effect on interest deductibility depends on what the investor does with the distributed amount. To the extent that it is used for personal use property and spending, future interest deductibility will again be trimmed down. Importantly however, the degree of effect may be much larger on a t-series distribution due to the larger ROC proportion, potentially being the entire annual withdrawal. (Once more, ROC does not necessarily equal the at-risk amount of a loan. Consult a qualified tax professional.)

Managing and servicing the loan

Principal repayments

Pursuant to the first two requirements for deductibility above, the borrower must make interest payments and be legally obliged to do so. Invariably the borrower will also have a legal obligation to pay the principal back to the lender, either on a fixed schedule, at the end of the loan term, or in whatever manner the parties may agree.

Principal repayments do not entitle the borrower to a deduction, though they do reduce the amount of the outstanding loan on which future interest will be calculated.

Compound interest

By agreement or through a lender’s concession, a borrower may be allowed to forego an interest payment in a year, with the amount then added or ‘capitalized’ to the principal debt. As the borrower will not have paid interest in respect of that year, no deduction will be allowed at that time for the capitalized amount. A deduction will be allowed as interest is paid on the outstanding balance in future, as long as all other requirements are met.

Taxpayer onus, recordkeeping, and linking sources & uses of borrowed money

Once the decision is made to proceed with a leveraged investment strategy, an investor must understand that the onus is on that person as a taxpayer to prove entitlement to tax benefits, in this case the deductibility of interest on investment loans. Given the range of issues canvassed in this bulletin, it should be clear that an investor carries a substantial burden in meeting that onus.

Often, a single loan advance may be used to purchase qualifying investments in a single account. Alternatively, that advance may arrive in a temporary holding account which is then allocated to a combination of places, possibly all deductible (at least at first), or a combination of deductible and non-deductible purposes. A degree further in complexity might be the use of a line of credit for these various purposes, from which future draws are taken, interest charges paid, and principal amounts repaid.

Whatever form the borrowing may take, good organization and good recordkeeping will allow an investor to better monitor and evaluate the effectiveness of the borrowing strategy. That also sets the stage for both tax reporting and tax-based decision-making.

[1] For more information, readers may consult Canada Revenue Agency Income Tax Folio S3-F6-C1, Interest Deductibility.

Interest equivalency

A tax tool for comparing interest to other investment returns

Rate of return on a portfolio is often front and centre in an investor’s mind. Understandable as this is, ultimately it’s about how much of those returns the investor will keep. The difference between the two is tax, which in turn depends on the type of income earned and the investor’s tax bracket.

This article deals with an individual earning income in a non-registered account, also known as an open account or cash account. With a range of variables in play, it can be difficult to follow the steps from initial return through tax calculation to spendable after-tax cash. A useful tool to help connect the arithmetic is interest equivalency.

Interest – Taking into consideration the tax trade-off

Interest is appealing for the part of a portfolio where certainty is the prime concern. For example, the issuer of a guaranteed investment certificate (GIC), agrees to pay a set amount of interest for the period of the contract.

This certainly provides valuable comfort to the investor, but an important trade-off from a tax perspective is that interest faces the full tax rate at any given income bracket.

Preferred taxation – Capital gains & Canadian dividends

Compared to interest, Canadian dividends and capital gains receive favourable tax treatment. They come at it from different routes, with the benefits emphasized at different income levels. Canadian dividends provide the best after-tax yield at low to mid brackets, giving way to capital gains at higher and top brackets.

Capital gains

There are two features that lead to the favourable tax experience from capital gains:

1. Deferral – While a security is held, no tax arises on changes in its price. This is also true if the investor holds a mutual fund that fluctuates according to price movement of its underlying securities. But a redemption/sale is a taxable event, and if the value has increased then the investor will realize a capital gain at that time.
2. Reduced inclusion rate – When there is a disposition, capital gains are said to be realized in that year, but only a portion of the capital gain is taxable. The “taxable capital gain” is derived by applying the income inclusion rate, which has ranged between 1/2 and 3/4 since 1971, but has been stable at 1/2 since 2000. The 2024 Federal Budget increased it to 2/3, while still allowing the 1/2 rate on the first $250,000 of an individual’s annual capital gains. (For trusts and corporations, the 2/3 rate applies to all capital gains.) The 1/2 rate is used in the examples to follow, on the assumption that the investor is an individual with less than $250,000 of annual capital gains.

The first feature allows tax-deferred growth. It is the second that is used in the interest equivalency calculation.

Canadian dividends

Like interest, Canadian dividends are taxed in the year earned, but the tax is calculated in two steps:

1. Gross-up – The ‘gross-up’ factor adds back the corporate tax, so the investor’s bracket can be used to calculate the tax as if the investor had earned the income that was really earned by the corporation.
2. Tax credit – The investor then gets a tax credit for the tax that the corporation has already paid.

This two-step process protects against double-taxation. The government’s revenue is split between the corporate tax and the personal tax, which is why an investor pays less on a dividend compared to the full rate for interest.

How interest equivalency works

Interest equivalency shows what amount of preferred income will give an investor the same after-tax spendable cash as a dollar of interest. Alternatively, it can be expressed as the higher amount of interest that equates to a dollar of preferred income. Either way, the result is expressed in dollars and cents.

Formula

Interest equivalency is shown in the following table at top tax bracket for each province, but it can be calculated at any income level by applying the following formula that uses marginal tax rates (MTR):

Interest equivalency = ( 1 – MTR^interest ) ÷ ( 1 – MTR^preferred )

Proof

It may be easier to see how this works by looking at an example, here using Alberta in the first row of the table:

Informing yourself with this tool

To be clear, interest equivalency is a tool used to compare investment returns; it is not a suggestion against interest returns in a portfolio. All income types have their respective features, benefits and risks. The tool can help advisors and investors understand, compare and discuss investment options and recommendations in a portfolio.

Denied tax credit for interest on student loans

At issue

As many a parent will attest, it can be very costly to put a child through post-secondary schooling. If the family does not have immediate resources available, it is common to consider borrowing to finance the need.

Fortunately, the tax system provides support to qualified loans through a non-refundable tax credit based on the amount of interest paid in the course of retiring such loans. To qualify, section 118.62 of the Income Tax Act (ITA) requires that the loan must be made “under the Canada Student Loans Act, the Canada Student Financial Assistance Act or a law of a province governing the granting of financial assistance to students at the post-secondary school level.”

Unfortunately, it’s almost an annual ritual that a case is reported where a past student is denied entitlement to the tax credit because the particular loan does not meet this criterion.

Mueller v. R., 2013 TCC 3

Two sisters were unable to obtain student loans under the federal government’s student loan programs, as their parents’ income was too high. Instead, they secured loans from a bank under its “Student Line of Credit” program, promoted by the bank as being at rates lower than under the student loan program.

On filing their tax returns in the year following graduation, their interest claims related to loan retirement were denied.

The sisters’ mother represented them in their appeals, and testified that a bank employee had represented that the loans were tax deductible. No reference to this effect appears in the promotional literature, and no one from the bank was called to testify.

It was acknowledged that the loans were not of the listed types in ITA 118.62, which the judge found was “fatal to their claim.” Appeals denied.

Sandhu v. R., 2010 TCC 223

The taxpayer was represented by his father in this appeal from a denied tax credit claim based on repayment of a loan to a bank.

The father provided a letter from a bank representative dated a week prior to the hearing. It read in part: “Due to my busy schedule, I will not be able to appear personally on April 7, 2010. The student loan to Gurdarshan Sandhu was made under the Canada Student Loan program.”

The judge allowed no evidential weight to the letter as no details of the loan were provided. Indeed, there was no way to be certain whether the referenced loan was even the loan at issue in court. The judge went so far as to speculate whether the writer may have been confusing student loans with some internal lending program the bank makes available for professional graduate programs. Appeal denied

2001-0074215E Refinancing-Student Loans

A taxpayer proposed to obtain a mortgage against his residence to reduce the interest rate on his existing qualified student loan. The Canada Revenue Agency (CRA) stated that interest on the new loan would not qualify for claiming the tax credit under ITA 118.62.

2010-0376461I7E Credit for Interest on Student Loan

The CRA was asked its opinion on whether interest paid on a student loan assigned to a collections agency would still qualify for the tax credit claim. The writer opined that the likelihood is that being under a collections process alone would not be sufficient to lose the tax credit claim, but that a court judgment would definitely extinguish it.

Practice points

A ‘loan to a student’ is not necessarily a “student loan” for the purpose of claiming the tax credit on the interest. To qualify, the loan must be arranged under the Canada Student Loans Act, the Canada Student Financial Assistance Act or a corresponding law of a province.
If challenging a denial of interest, make sure the facts are satisfied (so you don’t waste your time), and that you have the original documentary evidence to prove it. Second and third degree-removed hearsay assertions will not suffice.
A debtor should carefully consider the lost tax credit on qualifying student loans before including those debts in a refinancing or consolidation, even if on the face of it the new interest rate appears lower.
A person facing collections action should understand the importance of keeping up payments on student loans in order to preserve the tax credit entitlement, as this will be lost if a judgment is entered.