The first condition regarding a legal obligation to pay is usually straightforward, although it can be an issue in the case of non-arm’s length or inter-family loans where the payment obligations are not set out in writing. Also, if the payment of the interest is contingent and not absolute, the interest may not be deductible unless or until the contingency is resolved, if at all.
The third condition regarding reasonableness should be met if the interest rate is at or near a rate that would be payable on a loan between an arm’s-length borrower and lender (according to the Supreme Court of Canada in the Shell Canada case).
The second condition is normally the most contentious of the three. The courts have held that the borrowed money must be used directly for the purpose of earning income from property or a business. Indirect uses are not sufficient, except in “extraordinary circumstances”, as discussed under the subheading below with the same name.
For example, if I borrow money to purchase investments such as shares or mutual funds, the interest is normally deductible because the direct use of the borrowed money is to earn income from property (like dividends or interest income). Furthermore, if you borrow for the main purpose of earning capital gains (which are not considered income from property), such as a loan used to buy common shares, the courts have held that the interest is deductible as long as the property has the potential to earn income from property, such as dividends.
On the other hand, if you borrow for personal purposes and try to argue that the borrowing freed up your other capital to buy investments, the interest will not be deductible.
As such, one strategy, which has been blessed by the courts, involves a borrowing “switch”. For example, say I was thinking of taking out a loan for personal purposes. Instead, if I own some investments, I could sell the investments and use the proceeds for the personal purposes (the sale of the investments may trigger a capital gain or loss). If I then borrow to re-purchase the investments, the interest expense on the borrowing will be deductible because the direct use of the borrowing will be to earn income from property, even though an indirect use allowed me to use money for personal purposes. The Supreme Court of Canada confirmed this result in the 2001 Singleton case.
The “direct use” requirement must be met in each taxation year in which you claim the interest deduction. As a simple example, say I borrow to buy some investments and hold on to them for years 1 and 2, but sell them at the beginning of year 3 and use the proceeds for personal purposes. The direct use requirement will be met in years 1 and 2 but not year 3. As such, if the loan is still outstanding, no interest will be deductible in year 3.
In contrast, if I used the proceeds in year 3 to purchase another investment to earn income from property, the interest expense will continue to be deductible in year 3.
But what if I borrow money to buy an investment, later sell the investment at a loss, and continue to owe the borrowed money? If I use all of the sales proceeds to buy another investment, the interest expense will continue to be deductible in full. However, a special rule in section 20.1 of the Act provides that a portion of the interest expense will continue to be deductible even if I do not use the proceeds for income‑earning purposes. Basically, a proportionate amount of interest, based on the “loss portion” of the investment, will continue to be deductible even if I use the proceeds for other purposes, although some adjustment may be required in certain cases. (Interestingly, this special rule does not apply to borrowing made to purchase real estate or depreciable property.)