The Canada Revenue Agency (CRA) recently updated its guidelines on interest deductibility for borrowed funds used in investments. According to the Income Tax Act, interest is generally only deductible if borrowed money is used for earning income from a business or property. Notably, the CRA clarified that simply having an expectation of capital gains doesn’t meet this test. However, the deduction is still allowed for investments in common shares if there’s a reasonable expectation of dividends, even if dividends aren’t immediately paid.
In cases where an investment is replaced by another, or even if the new investment becomes worthless, the interest on borrowed money remains deductible. The CRA’s stance is that the key factor is the current use of funds, not the original use. This guidance also covers the “disappearing source” rule, which permits deductibility of interest when the borrowed funds, although no longer traceable to an income-generating purpose, were initially used for that purpose. Investors can benefit from this clarity to better understand how to manage their investments and related tax deductions.
For instance, if you borrow funds at a higher interest rate than the return you earn on your investment, the CRA still allows for the full deduction of the interest, provided the funds were borrowed for income-earning purposes. Additionally, if you use borrowed funds to invest in common shares where dividends may be paid later, the interest remains deductible, even when no immediate dividends are expected. However, if a corporation explicitly states it will not pay dividends, the CRA will disallow the interest deduction.
This updated folio provides essential guidance for those borrowing to invest, helping investors maintain compliance with the CRA’s rules.
