Deductibility of Investment Loan Interest: The Income-Earning Test

Key takeaways

• Interest on money borrowed to earn income from a business or property is deductible under paragraph 20(1)(c) of the ITA
• The purpose of the borrowing — not the current use of funds — determines deductibility
• The Lipson and Singleton cases established that tracing borrowed funds to income-earning use is essential
• TOSI (tax on split income) rules restrict the benefit of shifting deductible interest to family members
• The EIFEL rules (Excessive Interest and Financing Expenses Limitation) cap interest deductions for large businesses

Interest deductibility is one of the most litigated areas of Canadian tax law. The basic rule is straightforward — interest on borrowed money used to earn income is deductible — but the details have generated decades of court decisions.

The direct use test

For interest to be deductible, the borrowed money must be used for the purpose of earning income from a business or property. This is a direct-use test: the CRA will look at how the borrowed funds were actually deployed, not what the taxpayer intended to do with them.

If you borrow $100,000 at 6% to buy investments yielding 3%, the interest is still deductible — as long as you have a reasonable expectation that the investments will generate income (dividends, interest, or rental income). A pure capital appreciation play (investments that pay no income, like gold) may not qualify. The Supreme Court's decision in Ludco Enterprises confirmed that income must be a purpose, not the primary purpose.

Tracing through a chain of transactions

The Supreme Court's Singleton decision allows taxpayers to trace through a series of transactions. A lawyer who withdrew equity from a partnership to buy a house, then borrowed from the bank and returned the money to the partnership, could deduct the interest on the bank loan — even though the house was purchased — because the borrowed money was directly used in the partnership. Complex refinancing arrangements require careful tracing documentation.

EIFEL rules for large businesses

The Excessive Interest and Financing Expenses Limitation (EIFEL) rules, effective January 1, 2023, limit net interest and financing expenses for affected businesses to 30% of "adjusted taxable income" (essentially EBITDA for tax purposes). Groups with less than $250,000 of net interest expense are exempt. The rules primarily affect highly leveraged corporate groups and cross-border financing arrangements.