Almost every acquisition is financed, and the interest is usually the largest cost of the deal after the price. Whether any of it comes off taxable income is decided by Income Tax Act paragraph 20(1)(c), and by a purpose test that asks who borrowed, what they bought, and whether the two can still be linked years later.
Key takeaways
SECTION 01 OF 09
Section 18 says that in computing income from a business or property “no deduction shall be made” for “an outlay, loss or replacement of capital… except as expressly permitted by this Part” — paragraph (b), marginal note Capital outlay or loss. The Supreme Court has generally treated interest as exactly that.
Paragraph 20(1)(c) is the permission. Subsection 20(1) opens “Notwithstanding paragraphs 18(1)(a), 18(1)(b) and 18(1)(h)… there may be deducted such of the following amounts as are wholly applicable to that source”. Read the last five words. The deduction attaches to a source of income, and a source belongs to one taxpayer.
The marginal note on paragraph (c) is simply Interest. It permits deducting an amount “paid in the year or payable in respect of the year… pursuant to a legal obligation to pay interest on” “borrowed money used for the purpose of earning income from a business or property”, capped at “a reasonable amount in respect thereof”.
SECTION 02 OF 09
In Ludco Enterprises Ltd. v. Canada, 2001 SCC 62 the Supreme Court settled it: the test “is whether, considering all the circumstances, the taxpayer had a reasonable expectation of income at the time the investment was made.” An ancillary purpose to earn income is enough; it need not be the dominant one.
It was equally clear on the noun. “Income” there “refers to income generally… not just net income”, and courts “should not be concerned with the sufficiency of the income expected or received”. Interest exceeding the income earned does not, by itself, break the deduction.
A capital gain does not count. The CRA notes at ¶1.27 of Folio S3-F6-C1 that the phrase does not extend to a reasonable expectation of capital gains, citing Cassan, 2017 TCC 174. “I expect to sell this for more in five years” is a commercial answer, not the statutory one.
SECTION 03 OF 09
The statute says used, and the courts read that literally. In Bronfman Trust the Supreme Court said the Act “requires tracing the use of borrowed funds to a specific eligible use” and that “the onus is on the taxpayer to trace the borrowed funds to an identifiable use”.
Singleton v. Canada, 2001 SCC 61 added the point that decides real transactions: the steps in a financing are not collapsed into one. “The transactions in question are properly viewed independently”, and the sequence of cheques did not change the direct use of the funds.
The practical consequence is unglamorous. Borrow into an account holding nothing else, advance it to the closing, keep the flow of funds. Commingle it with operating cash and the taxpayer bearing the onus is rebuilding a link from a bank statement. Treadstone Law puts it plainly: “Interest is deductible only when borrowed funds are used to earn taxable income.”
SECTION 04 OF 09
If a corporation borrows and buys the assets of a business, the analysis is short. The money acquired the inventory, equipment, goodwill and contracts that generate income from a business, and the interest sits in the same company as the income it helped produce.
If an individual borrows and buys shares, the property acquired is shares, and income from shares is income from property — dividends. The purpose test is measured against the expectation of dividends, not the salary the buyer intends to draw. Treadstone Law’s asset-versus-share comparison covers the wider consequences of that fork.
Its article on deducting interest on an acquisition loan addresses both: “Both routes can potentially support an interest deduction, and both can also fail to, depending on facts.” Its piece on using a holding company is good on corporate mechanics but leaves tax to the accountant — read it for structure, not deductibility.
SECTION 05 OF 09
The CRA’s position at ¶1.70 of the folio is that interest on money borrowed to buy common shares is generally deductible “on the basis that at the time the shares are acquired there is a reasonable expectation that the common shareholder will receive dividends”.
Then the exception, which should be read before any shareholders’ agreement is signed: “If a corporation has asserted that it does not pay dividends and that dividends are not expected to be paid in the foreseeable future such that shareholders are required to sell their shares in order to realize their value, the purpose test will not be met.”
The saving position follows immediately: “if a corporation is silent with respect to its dividend policy, or its policy is that dividends will be paid when operational circumstances permit, the purpose test will likely be met.” Writing a no-distribution policy into the agreement answers the question against the buyer.
SECTION 06 OF 09
Where the seller leaves part of the price outstanding, no money is lent. The CRA states the distinction at ¶1.24: “The unpaid purchase price of property is not borrowed money, but ‘an amount payable for property’” — a debt that does not result from a loan, as the Federal Court of Appeal confirmed in Autobus Thomas Inc.
A vendor note is therefore tested under subparagraph (ii), covering “an amount payable for property acquired for the purpose of gaining or producing income… from a business”. That asks about the property, not the use of money, and there is no cash to trace — but it engages only if the note bears interest.
The obligation must also be real: the folio requires that “the liability is absolute and non-contingent”. An interest-free note produces no deduction, and one whose payments depend on the business hitting targets may produce no present obligation. Treadstone Law’s vendor-financing guide describes the note as a promise to repay principal “with interest, on a schedule”.
SECTION 07 OF 09
The common Ontario structure puts a holding company on top: Holdco borrows, Holdco buys the shares, and the interest lands in a company whose only asset is shares. The operating income is one level down — and subsection 20(1) permits only amounts “wholly applicable to that source”.
Two routes address it. The first is to lend the money down, which Treadstone Law describes as Holdco re-lending “some or all of the proceeds down to Opco, documented with its own intercompany promissory note”. The second is amalgamation, which the CRA accepts at ¶1.44: where the acquired corporation is wound up or amalgamated with the borrower, “a link… is readily established between the shares that were initially acquired (and have disappeared) and the assets formerly held” by it.
That is the tax basis of the debt push-down: “The amalgamated company’s own earnings directly service the debt.” The companion piece on amalgamating Holdco with the target flags the constraint buyers forget: the loan agreement “will typically require the lender’s consent”. That belongs in the covenant negotiation, not the year after closing.
SECTION 08 OF 09
Buyers refinance. Subsection 20(3), marginal note Borrowed money: “if a taxpayer uses borrowed money to repay money previously borrowed… the borrowed money is deemed to be used for the purpose for which the previous indebtedness was used or incurred”.
The deeming rule preserves the original character, so a refinance years after closing does not restart the tracing exercise — provided the new borrowing genuinely repays the old debt rather than sitting alongside it. Where a source disappears, section 20.1 (¶1.41) can deem borrowed money to remain in an income-earning use. A rescue provision, not a plan.
SECTION 09 OF 09
Every test above is applied to what happened, in the order it happened, on the documents that exist. Tracing is retrospective evidence and cannot be created later. The dividend policy sits in an agreement signed at closing; the borrowing entity is fixed by who signed the credit agreement; the note either bears interest or it does not.
Costs that are not interest have their own rule. Financing expenses under paragraph 20(1)(e) — commitment and agent fees, the cost of putting the borrowing in place — are deducted at “that proportion of 20% of the expense that the number of days in the year is of 365”: over five years, not at once.
Further limits sit beyond this paragraph — thin capitalisation in subsections 18(4) to (6), and the excessive interest and financing expenses rules in sections 18.2 and 18.21, which the CRA notes apply to tax years beginning after 30 September 2023. None is the usual reason a deduction fails. Paragraph 20(1)(c) is.
Sources
