Florence Marino, B.A., LL.B, TEP
Head of Tax, Retirement and Estate Planning, Individual Insurance, Canada
Florence Marino is the Head of Tax, Retirement and Estate Planning Services, and she provides tax, retirement, estate and insurance planning support and consultation to advisors regarding complex cases in the affluent and business markets. She leads a team of professionals providing this type of support and consultation across the country.
Many leveraged life insurance strategies assume that interest is deductible and factor tax savings derived from that assumption into illustrations provided to clients. To correctly assume that interest is deductible, there are many requirements that must be met. Also, careful practical steps must be taken to preserve the possibility of deducting interest. Even where the requirements are met and practical steps are taken, the client must have sufficient income to utilize interest deductions at the marginal tax rate assumed. This article outlines some of the main requirements and planning steps for interest deductibility.
What’s the use?
Borrowed money must be used for, or used to acquire property for, “the purpose of earning income from a business or property”. Income refers to things like interest, rents, royalties, business income or trading gains. Income does not include capital gains. For example, funds borrowed to invest in mutual funds that only generate capital gains will not earn “income”; therefore, the interest on such borrowed funds is not deductible. Interest on borrowed money to buy shares is deductible if the shares can be expected to pay dividends.
Interest is not deductible if borrowed money is used to earn exempt income or to buy a life insurance policy. In the context of leveraged life insurance strategies, if interest is assumed to be deductible, cash – not borrowed money – must be used to pay the premiums under a life insurance policy. And, in the context of immediate leverage, the cash used to pay continuing premiums can’t come from cashing in the investments purchased with borrowed funds from the year before because interest on that prior loan will not remain deductible.
There must be a direct link between the borrowed money and an eligible use. This means that the taxpayer must have a paper trail that demonstrates the flow of the borrowed money to the eligible use.
In the context of leveraged life insurance, consider the following example. A taxpayer purchases a life insurance policy and intends to leverage the cash value to provide cash for personal expenditures in retirement. If the taxpayer wants to be able to deduct the interest on the loan for tax purposes, they can’t simply use the loan proceeds (obtained by leveraging the cash value of the policy) to pay for personal expenditures. The interest is not deductible when the loan proceeds flow from the bank to the personal expenditures, which is not an eligible use. If instead, an investment portfolio is sold to meet personal cash requirements, and the investments are subsequently repurchased with the borrowed funds, the interest may be deductible since the borrowed funds have been used to acquire property that earns income.
Although this series of transactions is not offensive, actual sales and purchases of the investments must occur. Depending on the type of property, accrued capital gains or losses or income from property may be realized. Where there are capital losses realized on the disposition, a superficial loss may be triggered where the taxpayer or an affiliated person acquires and owns the same or identical properties or a right to acquire the property (“substituted property”) during the period that begins 30 days before, and ends 30 days after, the disposition of the property. An affiliated person includes, among others, the individual’s spouse, or common-law partner. The superficial loss is denied and added to the cost base of the substituted property, so that on a future disposition, the loss will increase, or the gain will decrease.
Cash damming is another method enabling taxpayers to link borrowed funds to a specific use. Cash damming segregates borrowed funds (typically in a separate account) from funds received from other sources, such as business operations. The funds from other sources are used for non-eligible purposes such as the acquisition of a life insurance policy. The borrowed funds are used for eligible purposes, such as the acquisition of investment assets or investment in the business.
Exceptions to the direct use test
Borrowed money may be used to redeem shares, pay dividends to a shareholder or return capital to a shareholder, or partner. Although the direct use of these funds is to make a distribution, the Canada Revenue Agency (CRA) accepts that the borrowed money is used to “fill the hole” created by removing the capital. As a result, the CRA accepts that the purpose test is met, provided the distribution does not exceed the capital of the corporation and that the capital, before it was distributed, was being used for purposes that would have qualified for interest deductibility had the capital been borrowed money. “Capital” for this purpose generally includes contributed capital and accumulated profits (generally, retained earnings). Similarly, in the case of a partnership, the capital would generally be the balance in the partner’s capital account.
Where money is borrowed to make an interest-free loan to a wholly owned corporation (or in cases of multiple shareholders, where shareholders make an interest-free loan in proportion to their shareholdings) and the proceeds have an effect on the corporation’s income-earning capacity, thereby increasing the potential dividends to be received, the CRA allows a deduction for the interest. This applies equally to interest on money borrowed by a shareholder to contribute capital to a corporation or by a partner to contribute capital to a partnership.
Simple vs. compound interest
Interest is deductible when it is paid or payable (depending upon the method regularly followed by the taxpayer – cash basis taxpayers when paid; accrual based taxpayers when accrued) pursuant to a legal obligation. The amount of interest also must be “reasonable” to be deductible.
A deduction for compound interest (i.e., interest on interest) is allowed if it is paid in the year and the related simple interest is deductible. Note that, unlike simple interest, which is deductible when paid, or payable (i.e., accrued), compound interest is only deductible when it is physically paid. Compound interest is not deductible in the year it arises if it is simply added to the outstanding loan balance (i.e., capitalized). In the context of leveraged life insurance strategies, this means that if interest is capitalized, the interest arising on that interest (i.e., compound interest) will only be deductible when it is paid. Since many of these loans intend to be outstanding until the death of the insured, the compound interest will only be paid, and therefore, deductible at death.
To avoid this problem, careful structuring is required to ensure that simple interest is paid each year so that no compound interest arises. Typically, this is done by paying the simple interest out of pocket, and then taking an additional loan advance equal to the interest to replace the funds previously used to pay the interest. Note that these advances must still meet the requirements outlined previously, including the requirement to use the funds for the purpose of producing income.
Limitations on interest deductions
Interest must be “Reasonable”
A general limitation on interest deductibility is that it will only be deductible to the extent that it is reasonable in the circumstances. To determine whether or not an interest rate is reasonable, consideration should be given to prevailing market rates for debts with similar terms and credit risks. As stated in the Shell Canada Limited v. Canada,  3 S.C.R. 622, “Where an interest rate is established in a market of lenders and borrowers acting at arm’s length from each other, it is generally a reasonable rate […]”.
International profit shifting
Private Canadian corporations that are part of a group that includes non-resident corporations, may be impacted by an interest deductibility limitation introduced to prevent international profit shifting (See Budget 2021 and leveraged life insurance.)
Special rules in Quebec
In Quebec, there is an additional test with respect to investment expenses that may limit interest deductions. These rules limit the deductibility of investment expenses to the amount of investment income earned from passive investments in property during the year. These rules are applicable only to individuals and trusts. There are carryover provisions (3 years back and forward indefinitely) that allow the deduction of unused investment expense deductions in other years. Investment income includes such things as taxable dividends, interest, royalties, taxable capital gains, foreign investment income and life insurance policy gains. Rental properties are excluded from the rules altogether. Investment expenses are all expenditures incurred to earn income from property (other than rental income) including the following: investment administration or management expenses, stock or securities custody expenses, fees paid to investment advisors, interest on money borrowed to acquire bonds, stock, or mutual funds, and certain partnership losses.
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