Under the Income Tax Act, interest paid or payable pursuant to a legal obligation on “borrowed money used for the purpose of earning income from a business or property” is deductible — the statutory test in section 20(1)(c) that determines whether interest on acquisition debt can be written off.
Section 20(1)(c)(i) permits the deduction for borrowed money used for the purpose of earning income from a business or property. Section 20(1)(c)(ii) does the same for an amount payable for property acquired for the purpose of gaining or producing income from the property or from a business. Both are capped at “a reasonable amount in respect thereof” — the Act does not allow deducting more than the interest is actually worth.
The provision carries its own carve-outs, and they matter to how an acquisition is structured: both paragraphs explicitly exclude “borrowed money used to acquire property the income from which would be exempt or to acquire a life insurance policy”. A holding company that borrows to acquire the shares (or assets) of an operating business is squarely within the general test where that business is expected to earn income — business income directly, or dividend income on the shares — but the same borrowing used instead to fund a life-insurance-funded arrangement would not qualify, because the Act says so in the same sentence that creates the deduction.
Section 20(3) matters just as much in a financing structure that starts with a bridge facility: money borrowed to repay an earlier borrowing keeps the original borrowing’s purpose for deductibility purposes. A holdco that draws a short-term bridge to close, then repays it with a BDC facility, does not have to re-establish the purpose test from scratch on the replacement loan — the character of the original borrowing carries over.
Newco borrows $2,000,000 to acquire 100 percent of the shares of an operating target expected to pay dividends and continue generating business income. Say the loan carries interest at 8 percent a year, an illustrative rate for this example — that is $160,000 of interest annually. Because the borrowed money was used for the purpose of earning income from a business (through the acquired shares), the interest qualifies for deduction under s.20(1)(c)(i), subject to the amount being reasonable. Had Newco instead borrowed the same $2,000,000 to fund a life-insurance-backed buy-sell arrangement, the explicit s.20(1)(c)(i) carve-out would deny the deduction outright, regardless of the rate.
See also: bridge financing, Business Development Bank of Canada and leverage multiple.
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