Taxing Issues - Interest Deductibility - Standard Life

The Standard Life Assurance Company of Canada
August 2008
Interest Deductibility
The potential to maximize returns attracts many taxpayers to the concept of interest deductibility. It has
the potential to let taxpayers - either individuals or corporations – to borrow funds to leverage their
positions and maximize returns. Tax considerations clearly have a considerable impact on the calculation
of returns, since whether or not the financing charges are deductible for tax purposes will have a
significant influence.
This document reviews how interest can be made tax deductible. Of course, when borrowing money it’s
always important to consider all the issues (financial risk, etc.) relating to the transaction before
proceeding. Independent legal and accounting advice is necessary.
At first glance, interest deductibility seems straightforward. However, there have been significant changes
in this area in recent years. Legislative changes have been proposed (notably the Reasonable
Expectation of Profit (REOP) draft proposals in 2003). Many taxpayers are very interested in whether or
not these legislative changes proceed.
I. Background
The Income Tax Act (Canada) (ITA) contains specific provisions relating to interest deductibility. There
are general rules that determine the criteria that must be met for interest to be deductible, as well as
some specific rules that modify the general provisions.
One criteria is that the borrowed funds must be used “for the purpose of earning income from a business
or property.” 1 The Canada Revenue Agency (CRA) had traditionally held that interest expense would not
be deductible unless the taxpayer realized a profit (had net income) from the underlying property or from
carrying on the business activity, after taking the interest expense into account.
CRA’s position appears to be based on two factors. First, CRA states that the way in which the ITA was
structured made it clear that having “net income” was at issue. Second, a taxpayer could not be viewed
as having a source of property or business income unless the property or business activity carried a
“reasonable expectation of profit” (REOP).
There were two landmark tax cases at the Supreme Court in 2001 (Ludco and Singleton), which
successfully challenged CRA’s position. 2 These two Supreme Court cases established that “income”
could not be interpreted as “net income” or “profit.” Thus, CRA could not limit a deduction of interest
expense to the investment or business income actually earned – interest charges could create a “tax loss”
(unless of course some other specific rule in the ITA prohibited the deduction of the interest).
1 See subparagraph 20(1)(c)(i) of the Income Tax Act (Canada) (ITA).
2 Ludco Enterprises Ltd., Brian Ludmer, David Ludmer, and Cindy Ludmer v. Her Majesty the Queen, 2001 CarswellNat 2017, 2001
SCC 62, 2001 DTC 5055 (Eng.), 2001 DTC 5518 (Fr.) (Ludco); Her Majesty the Queen v. John R. Singleton, 2001 CarswellNat
2019, 2001 SCC 61, 2001 DTC 5533 (Eng.), 2001 DTC 5545 (Fr.) (Singleton).
PC 6141B-08-2008

As a consequence of these cases, on October 31, 2003 CRA released its interpretation bulletin -
Interpretation Bulletin IT-533 – Interest Deductibility and Related Issues - on this topic, incorporating the
outcomes of the Singleton and Ludco decisions. Unless the legislation was changed, CRA had to abide
by the positions taken at the Supreme Court level on the interpretation of the current legislation. (This of
course assumes that CRA could not challenge the interest deductibility on some other basis, e.g., the
General Anti-Avoidance Rule (GAAR), etc. Taxpayers and their advisors are currently awaiting the
outcome of the Lipson case where CRA in fact applied GAAR. This case was heard at the Supreme
Court in April 2008, but the judges have not yet rendered a decision as to whether the application of
GAAR will be overturned. A decision is expected in the autumn of 2008. 3 )
The Department of Finance (Finance) wanted to remedy an outcome that could result in a considerable
loss of tax revenues to the government. On October 31, 2003 it introduced draft legislation, which
contained significant revisions to the interest deductibility rules. Under these proposals, which are
generally referred to as the “REOP draft proposals,” interest (and other expenses) could not be used to
create a loss in the year, unless it was reasonable to expect that over the lifetime of the investment (or
the carrying on of the business) a cumulative profit would be earned. It is not possible to predict how and
when the government will proceed with these proposed changes.
Quebec addressed this issue as well. Proposals contained in Quebec’s 2004 budget have actually been
enacted. These are discussed in Section III below.
The following discussion reviews current legislation. It focuses on borrowings incurred to acquire various
investment products, and touches upon the requirements for borrowings incurred for business purposes.
It briefly examines the REOP rules as well. Finally, it touches upon some planning opportunities.
II. General Requirements for Interest Deductibility
The ITA contains specific conditions that must be met for interest to be deductible:
• It must be paid or payable for the year (depending upon the method regularly followed by
the taxpayer for computing income);
• There must be a legal obligation to pay the amount;
• The amount must be reasonable, and;
• The borrowed money must be used to earn income from a business or property (other
than to earn exempt income or to acquire a life insurance policy). 4
See Section IV for specific rules relating to the acquisition of life insurance products (segregated funds,
annuities and life insurance).
The ITA does not contain a definition of “interest.” However, CRA considers an amount to be “interest” if it
meets the following criteria:
• The amount is calculated on a day-to-day basis;
• The amount is calculated on a principal sum (or a right to a principal sum), and;
• The amount represents compensation for the use of the principal sum (or the right to the
principal sum). 5
3 Supreme Court of Canada, Court File # 32041
4 See paragraphs 20(1)(c)(i), (ii) of the ITA.
5 See paragraph 1 of Interpretation Bulletin IT-533 – Interest Deductibility and Related Issues (IT-533), dated October 31, 2003.
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August 2008
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We will now review each of the four specific conditions:
(a) Interest must be paid or payable for the year
Taxpayers who use a cash method for calculating income would deduct interest on a cash basis. Those
who use the accrual basis would deduct interest on an accrual basis. However, in the case of compound
interest, this may only be deducted when paid, even for taxpayers otherwise using the accrual method. 6
(b) Legal obligation to pay the amount
There must be a legal obligation to pay the amount. Generally this means that the taxpayer must be
bound under the obligation. The creditor must be able to seek legal recourse in the event of non-payment.
A Federal Court of Appeal case, Shell (FCA), contains a lengthy analysis of interest deductibility. On the
legal obligation issue, the judge in this case stated, “there is no such thing as a deduction for money paid
voluntarily; there must be a legally recognizable duty to pay.” 7 He also made the point that a payment
may look like interest, but may in fact be a distribution of profits, or a payment on account of principal. He
did not consider such payments to be interest. 8
Taxpayers are best served when there is a document formalizing the loan and containing all relevant
provisions (e.g., repayment, how the interest is calculated, etc.). Where there is no documentation, the
taxpayer may not be able to substantiate that there was indeed a legal obligation to pay the amount.
(With a policy loan, the insurance contract, or other relevant documents, would contain this information.)
If the payment of interest is contingent (e.g. obligation to pay interest is contingent upon an event that
may or may not occur after the year), the interest cannot be deducted because there is no legal obligation
to pay the amount. 9 When the contingent amount relating to a prior year is then paid in a subsequent
year, the amount may not be deductible because it may not meet the condition that it be “paid or payable
for the year”. 10
(c) The amount must be reasonable
The ITA limits the deduction for interest to “… an amount paid in the year or payable in respect of the
year … or a reasonable amount in respect thereof, whichever is the lesser.” 11 Thus, it is clear that any
deduction for interest expense will be capped at a reasonable amount.
In IT-533 CRA also stated “In considering whether or not an interest rate is reasonable, consideration will
be given to prevailing market rates for debts with similar terms and credit risks, and the existence of any
issue premiums.” 12
6
See paragraph 20(1)(d) of the ITA. Also, paragraph 5 of IT-533.
7
See Her Majesty The Queen and Shell Canada Limited, 1988 CarswellNat 170, (R. v. Shell Canada Ltd.), 98 DTC 6177, (Shell
Canada v. Canada) (Shell (FCA))
8
See Shell.
9
See paragraph 18(1)(e) of the ITA. Also, paragraph 6 of IT-533.
10
See paragraph 20(1)(c) of the ITA. Also, paragraph 6 of IT-533.
11
See paragraph 20(1)(c) of the ITA.
12
See paragraph 7 of IT-533.
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We note that the Shell (FCA) case also dealt with reasonableness. The judge raised the issue of how
reasonableness is interpreted, and determined that there were two possibilities:
“… The Court may ask what is a reasonable rate for the lender to charge. Or, the Court
may ask itself what is a reasonable rate of interest for the borrower to pay. In my view,
since the provision is about the reasonableness of the deduction of the interest payments
claimed by the borrower, the appropriate question is the latter. It should be pointed out
that, in the majority of situations, the answer to both of these questions would probably be
the same.” 13
This case later went to the Supreme Court. The judge stated, “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
…” 14
Whenever borrowers enter a lending arrangement, they should ensure that they can meet this condition.
The borrower’s specific circumstances will no doubt have a bearing on this determination.
(d) The amount must be used to earn income from a business or property
Capital gains do not constitute income from property (see Section III for a discussion of the Quebec
rules). Thus, the taxpayer needs to be able to demonstrate that the interest is being incurred to earn other
than capital gains.
As stated above, prior to the Singleton and Ludco decisions, CRA had always maintained that there had
to be “net income” or a “profit.” With these decisions, this is no longer the case. As stated in Ludco, and
cited by CRA in its IT-533,
“The plain meaning of s. 20(1)(c)(i) does not support an interpretation of ‘income’ as the
equivalent of ‘profit’ or ‘net income’. Therefore, absent a sham or window dressing or
similar vitiating circumstances, courts should not be concerned with the sufficiency of the
income expected or received.” 15
Taxpayers need to carefully arrange any transaction and ensure that they avoid transactions that CRA is
able to successfully contend are a sham or window dressing. CRA may in some situations be able to
successfully invoke the General Anti-Avoidance Rule provisions. 16 This happened recently with the Lipson
case, a Federal Court of Appeal case dealing specifically with interest deductibility. 17 As stated above,
this case is currently before the Supreme Court of Canada.
Where we are looking at how the borrowed funds are used, two questions come to mind. These are, does
“use” encompass both direct and indirect use and, does “use” mean first use or current use?
CRA is pretty clear on the first item. It also has support from the courts. As stated by CRA,
“… the onus is on the taxpayers to trace or link the borrowed money to a specific eligible
use, giving effect to the existing legal relationships.” 18
13 See Shell (FCA).
14 See paragraph 7 of IT-533.
15 See paragraph 10 or IT-533.
16 See subsection 245 of the ITA.
17 See Jordan B. Lipson and Her Majesty The Queen, 2006 Carswell 982, 2006 TCC 148, D.T.C. 2687 (Eng.), [2006] 3 C.T.C. 2494,
also Lipson, E. et al. v. the Queen (FCA) A-231-06, A-230-06, 2007 FCA 113, 2007 CAF 113
18 See paragraph 14 of IT-533.
The Standard Life Assurance Company of Canada
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With respect to this issue, it is clear that direct use is the criterion. Taxpayers may want to read the IT-533,
which may be accessed via the CRA web site. 19 IT-533 makes some very important points.
CRA discusses how borrowings can be restructured in order to meet the direct use test. 20 This
restructuring may, in fact, represent a tax savings opportunity for many taxpayers. In the example, a
taxpayer owns fully-paid-for investments, yet has a mortgage on his or her condo. The shares are sold,
and the proceeds are used to repay the non-deductible mortgage on the condo. The taxpayer then takes
out a new loan for investment purposes. The net effect of the restructuring is that the interest becomes
deductible.
The appropriate use of cash damming is also discussed in the context of a taxpayer’s being able to meet
the direct use test. 21 Also, IT-533 contains a discussion of rules that apply in other circumstances (e.g.,
borrowing to redeem shares, return capital or pay dividends; return capital to a partner; to make interestfree
loans to employees where these loans are not received by the employee in a shareholder capacity,
etc.). 22
The second issue relates to where replacement property is acquired. Let’s assume that the borrowed
funds are used to acquire a specific investment. The investment is sold and the proceeds are reinvested
in another asset. CRA permits a flexible approach to linking. Refer to IT-533 for a discussion of these
rules, especially in situations where the value of the replacement property is less than the amount of the
funds that were initially borrowed. 23
The ITA contains specific “disappearing source” rules. 24 In certain circumstances, interest charges may
remain deductible, even if the funds can no longer be traced to any income earning use. This typically
occurs where borrowed funds are used to acquire an investment, and the investment is sold at a loss.
Even where the proceeds from the sale are used in their entirety to repay the loan, these proceeds may
not be sufficient to retire the loan completely. In circumstances like this, the ITA provision may provide
relief and allow the taxpayer to continue to deduct interest charges.
III. Quebec Rules
Quebec introduced new rules governing investment expense deductibility in its 2004 budget. These rules
apply to passive income, not to business income or rental income.
While transitional rules were in place for the 2004 taxation year, these rules are now in effect. (They even
apply for investments acquired prior to the introduction of these rules.) Thus, Quebec residents will have
to assess the impact of both the Federal and Quebec rules, since separate tax returns are filed for each
jurisdiction.
Quebec limits investment expenses (including interest) to investment income for the year. There is a
three-year carry-back and unlimited carry-forward for expenses that cannot be applied in a year.
For Quebec tax purposes, taxable capital gains (except those in respect of which the capital gains
exemption has been claimed) enter into the calculation of “investment income.” When we are looking at
dividends, the taxable amount of the dividend is included. (For dividends from taxable Canadian
corporations, the grossed up dividend is included here. Thus, 145% of an “eligible dividend” is included,
whereas only 125% of ineligible dividends would be included.)
19
IT-533 may be accessed at: http://www.cra-arc.gc.ca/E/pub/tp/it533/README.html
20
See paragraphs 14 and 15 of IT-533.
21
See paragraph 16 of IT-533.
22
See paragraphs 22 to 26 of IT-533.
23
See paragraph 18 of IT-533.
24
See subsection 20.1 of the ITA.
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The Quebec calculations are quite mechanical. Investment expenses are simply compared with
investment income for a year. This being the case, Quebec taxpayers will want to avoid situations where
interest expenses for a year would be capped. Thus, where borrowings are required, the Quebec
taxpayer will typically want to have incurred them for business purposes, or for the purpose of acquiring
rental income, as the interest on these loans will not be capped. (Other general conditions relating to
deductibility described earlier must still be met.)
IV. Some Specific Rules
This section reviews some rules relating to specific investments. This list is by no means definitive. Of
course, the other conditions relating to interest deductibility still need to be satisfied (e.g.,
reasonableness, legal obligation, etc.).
(a) Borrowing to acquire an interest in a life insurance policy
The ITA prohibits a deduction for borrowings that are used to purchase life insurance. 25
Where, however, life insurance is acquired because a (restricted) financial institution requires the policy as
collateral, there are specific rules dealing with what portion of the life insurance premiums may be
deducted. 26
(b) Policy loan interest
Tax rules allow for a deduction for policy loan interest. For detailed information on policy loans, please refer
to our document entitled Policy Loans [PC 6140], which is part of the Taxing Issues series.
There is a prescribed form that must be completed by the insurer and the policyholder. Also, the general
conditions relating to interest deductibility (as outlined in Section II above) are applicable.
(c) Borrowing to acquire segregated funds
There are some exceptions to the ITA rule that interest incurred to acquire life insurance is not deductible.
Interest relating to the acquisition of segregated funds is deductible. 27
(d) Borrowing to acquire a Non-Prescribed Annuity
The ITA allows a deduction for interest for the acquisition of a non-prescribed annuity. These rules limit the
deduction to the amount of the accrued interest included in income for the year. 28 Of course, where a
deduction is claimed for the interest expense, this may limit the amount otherwise qualifying for the pension
credit. 29
25 See subparagraph 20(1)(c)(ii) of the ITA.
26 See paragraph 20(1)(e.2) of the ITA.
27 See paragraph 20(2.2)(c) of the ITA.
28 See subparagraph 20(1)(c)(iv) of the ITA.
29 See paragraph 118(8)(b) of the ITA.
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(e) Borrowing to acquire a Prescribed Annuity
Interest to acquire a prescribed annuity is specifically not deductible. 30
(f) Borrowing to acquire an investment carrying a stated interest or dividend rate
The Singleton and Ludco decisions provided that interest expenses could be claimed so long as the
borrowing was incurred to earn income from a business or property. The previous requirement that there
needed to be net income or profit no longer holds.
In IT-533, CRA specifically states:
“Where an investment (e.g., interest-bearing instrument or preferred shares) carries a
stated interest or dividend rate, the purpose of earning income test will be met ‘absent a
sham or window dressing or similar vitiating circumstances’ (Ludco). Further, assuming all
of the other requisite tests are met, interest will neither be denied in full nor restricted to the
amount of the income from the investment where the income does not exceed the interest
expense . . . ” 31
Thus, under the current legislation, where a taxpayer acquires preference shares carrying a 4% stated
interest, and incurs interest at say 8%, CRA cannot deny a deduction for the 8%, even though it exceeds the
5.8% (4% plus a 45% gross up, assuming that we are referring to eligible dividends) included in income. (It
is little wonder that Finance was unhappy at the outcome of the Singleton and Ludco cases).
(g) Borrowing to Acquire Common Shares
CRA’s position is that where the borrowings are used to acquire common shares, the interest charges will
be deductible “on the basis that there is a reasonable expectation, at the time the shares are acquired, that
the common shareholder will receive dividends.” 32 CRA states that each situation will be looked at based on
the particular facts. 33
The above comments also apply to investments in mutual fund trusts and mutual fund corporations. (See (c)
above for investments in segregated funds sold by Insurance companies.)
(h) Borrowing to Make Employer Contributions to a Registered Pension Plan (RPP) or Deferred Profit
Sharing Plan (DPSP)
The ITA permits an employer to deduct interest relating to loans taken out to make contributions to an RPP.
This provision allows interest to be deducted for loans relating to both past service and current service
contributions. 34 (Note here that an Individual Pension Plan (IPP) is a RPP.)
Similarly, an employer may deduct interest charges for loans incurred to make contributions to a DPSP. 35
30
See subparagraphs 20(1)(c)(i),(iv) of the ITA.
31
See paragraph 31 of IT-533.
32
See paragraph 31 of IT-533.
33
See paragraph 31 of IT-533.
34
See paragraph 18(11)(c) of the ITA.
35
See above.
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(i) Borrowing to Make Personal Contributions to Registered Plans
While, as stated above, an employer can deduct interest charges relating to its contributions to RPPs and
DPSPs, this is an exception to the general rule which prohibits a deduction for interest charges for loans
incurred for contributions to registered plans (RRSPs, RPPs and RESPs). 36 Thus, it is clear that where an
individual incurs a personal loan in order to contribute to these arrangements, the interest is not deductible.
While a Retirement Compensation Arrangement (RCA) is not a registered plan, the same provision in the
ITA prohibits a deduction for loans incurred by employees to contribute to RCAs. 37
(j) Return of Capital
Investors may acquire mutual fund units offering a return of capital (ROC). There may be interest
deductibility concerns where these are acquired with borrowed funds. CRA has stated that:
“Where there is a ROC to the unit holder of a mutual fund (without any disposition of any
portion of the property), it would be appropriate to consider that the income-earning
purpose of the original borrowed money may no longer be met with regard to such returned
capital. Therefore, when distributions from a mutual fund involve a ROC to the unit holder,
the current use of the borrowed money with regard to such returned capital would need to
be determined, with the other requisite interest deductibility tests applied to such use … if
we assume that the ROC … is not used for an income earning purpose but is used for
personal use, in our view, the interest on that portion of the borrowed money that relates to
the return of capital … would not be deductible since its current use is personal …” 38
Thus, with leveraged investments such as these, an investor will see an erosion of their claim for interest
deductibility. There will be similar concerns with investments such as income trusts.
(k) Contributions to a Tax-Free Savings Account
Taxpayers who are age 18 or over will be able to open a Tax-Free Savings Account (TFSA), effective
January 1, 2009. Specific tax rules disallow a deduction for interest relating to funds borrowed for making
contributions to these plans. 39
V. REOP Draft Proposals of October 31, 2003
If enacted, the draft proposals of October 31, 2003 will have a far-reaching impact. Finance originally
intended to make these proposals effective for taxation years beginning after 2004. However, Finance
continues to study the situation, and it is not possible to forecast what will happen.
As stated above, the Supreme Court did not accept CRA’s view that interest expenses could only be
claimed in situations in which there was a “profit” or “net income” from a business or property. (A tax loss
could not be created on account of interest and other expenses.) The REOP proposals were meant to
remedy this.
36 See subsection 18(11) of the ITA.
37 See paragraph 18(11)(e).
38 See Technical Interpretation # 2007-0236351E5 dated August 21, 2007.
39 See subsection 18(11) of the ITA.
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Briefly, if in a taxation year a taxpayer realized a profit or net income from the business or property after
deducting interest charges (as well as certain other expenses), the proposals would have no effect. If,
however, a loss arose, the loss could only be deducted if the “reasonable expectation of profit” test was met.
Under this test, the taxpayer would have to establish whether it was reasonable to expect that a cumulative
profit would be realized for the period that the taxpayer has carried on, or can reasonably be expected to
carry on, the business, or has held, or can reasonably be expected to hold, the property. Finance intended
that these new rules be applied for taxation years commencing after 2004, even to existing investments (or
businesses).
While the Quebec rules take into account capital gains (or losses) in applying its rules, the Federal rules
specifically ignore these. Even though not stated in the draft legislation, Finance has said that the rules
would generally not apply to common shares.
Tax practitioners attacked these draft proposals with considerable zeal. The legislation contained a number
of deficiencies (e.g., losses fall off the table if they cannot be applied in a year since the legislation did not
allow for a carry-forward or carry-back period, there are difficulties in determining the period over which
REOP to be calculated, etc.). Finance has not progressed with these measures.
It is impossible to anticipate whether Finance will resuscitate these measures, or whether it will introduce
new measures. Since Finance did not intend to grandfather existing investments, there is no assurance that
there will be grandfathering with any new measures.
VI. Other Considerations
(a) Impact on $750,000 Capital Gains Exemption
When the capital gains exemption was introduced, there were special rules that ground down the amount of
the otherwise available capital gains exemption. Taxpayers had to calculate their Cumulative Net Investment
Loss (CNIL). Essentially, CNIL is a running account (with this calculation starting for taxation years
beginning after 1987) representing the amount by which investment expenses (including interest) exceed
investment income, with the CNIL grinding down the otherwise available capital gains exemption. 40 The
thinking behind this proposal was that since there may already have been tax savings relating to interest
expenses for the acquisition of property, it was not appropriate to allow the capital gains to be exempt. A
taxpayer could unduly increase his or her tax savings.
While the $100,000 capital gains exemption is long gone (eliminated in 1994), the enhanced capital gains
exemption for certain shares of small businesses, as well as certain farming and fishing property, remains. 41
Hence, taxpayers who may make use of this exemption should remember that any interest charges they
incur for investment purposes would enter into the calculation of CNIL and will have a bearing on whether
they can claim the full $750,000 capital gains exemption. 42
40
See definition of “cumulative net investment loss” in subsection 110.6(1) of the ITA.
41
See section 110.6 of the ITA.
42
Pursuant to subsections 110.6(2), (2.1) and (2.2), the capital gains exemption has been increased to $750,000 for dispositions of
certain qualifying property on or after the March 19, 2007. (A $500,000 exemption was available for dispositions prior to that
date.)
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VII. Planning Opportunities
(a) Loans to Earn Property Income vs. Loans for Business Purposes and/or Rental Property Purposes
As noted, residents of Quebec are only able to deduct interest expenses to the extent that the investment
income for that year exceeds the investment expenses for that same year. Thus, where investment
expenses cannot be deducted for a taxation year, and these amounts cannot be applied in the three prior
taxation years, tax savings will not be realized until a later year when the taxpayer can apply these
expenses. Since these rules do not apply for business income and rental income, taxpayers resident in
Quebec may want to incur loans for either of these two purposes.
(b) IPP v. RRSP Contributions
If an individual were to incur a loan so that he or she could make RRSP contributions, specific rules in the
ITA prohibit a deduction for the interest. 43 However, if this person were an employee, the employer could
deduct interest relating to loans taken out to make contributions to an IPP. 44
The owner of an incorporated business may thus wish to establish an IPP, and fund the contributions with
borrowed funds. IPPs are already the retirement vehicle of choice for many older employee-shareholders.
We note that the combined employer-employee contributions that may be made to the IPP by these older
employee-shareholders are generally higher than the amount that the individual could contribute to an
RRSP. The added tax savings on the interest is another advantage that an IPP offers.
(c) Restructuring Loans
As discussed in Section II (see discussion under (d)), CRA sanctions certain restructurings. Thus,
taxpayers who have non-deductible debt may want to restructure it so that interest on it becomes
deductible. The transactions will have to be carefully structured in order to ensure that all the
requirements for interest deductibility are met. Professional assistance is necessary.
(d) Loans to Spouses
Loans to spouses have been an effective way to split income. While a new pension splitting regime has
been introduced for the 2007 and later taxation years, not all taxpayers (typically those who have not yet
attained age 65 since they may not yet be in receipt of a life annuity from a pension plan) will benefit from
these rules. Thus, this form of income splitting is still an advantage to this group. 45
The ITA contains specific rules on spousal loans. 46 Where the rules are not met, income attribution may
apply (i.e., the income and capital gains from the property are attributed back to the spouse who made the
loan).
Where interspousal loans are made, interest should be charged at no less than the prescribed rate (or an
arm’s-length rate, where this is lower), with the interest being paid no later than 30 days after the end of
the calendar year (i.e., by January 30 th of the following year).
43
See paragraph 18(11)(b) of the ITA.
44
See paragraph 18(11)(c) of the ITA.
45
See Department of Finance News Release 2006-61: Canada’s New Government Announces Tax Fairness Plan, issued October
31, 2006.
46
See subsection 74.5(2) of the ITA. Also, Interpretation Bulletin IT-511R – Interspousal and Certain Other Transfers and Loans of
Property, dated February 21, 1994.
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Of course, the spouse incurring the loan will want to make sure that all of the other conditions for the
interest to be deductible are met (see Section II).
(e) 10/8 Type Strategies Involving Life Insurance Policies
Many insurers offer so-called10/8 type strategies. These are generally of two types. The first type is an
arrangement involving a policy loan, where an equivalent amount is placed in an investment account
within the policy and earns interest at a somewhat lower amount.
The second type has the policyholder pledging the policy to a lender. In this case, the borrower receives
cash from the lender, which is then used for investment purposes. This type of arrangement is used in
situations where the insurer does not permit policy loans. The insurer will typically have made
arrangements with a lending institution that will advance funds, using the policy as collateral.
These types of arrangements are attractive to borrowers who are able to deduct the interest on the policy
loan or on the loan obtained from the financial institution to which they have assigned the policy. In order
to deduct the interest, all of the conditions relating to interest deductibility will have to be met. In the case
of a policy loan, all of the additional conditions relating to policy loans need to be met. (For more
information, refer to our companion document in this series: Policy Loans [PC 6140].)
CRA has expressed concern with respect to certain aspects of these arrangements. They issued a
Technical Interpretation in 2004 that dealt with the first type of arrangement (i.e., one having a policy
loan). It indicated that only a reasonable amount of interest (on the policy loan) would be deductible. CRA
stated:
“Of relevance in determining whether the interest rate is reasonable would be
comparisons to the rate of interest being charged for policy loans under UL policies that
do not offer the stepped up rate and the rate of interest that is being charged by other
lenders with similar credit ratings.” 47
It should be noted that this position might be considered to be at odds with comments made by the judge
in the Shell (FCA) case, which we cited above. We repeat them here:
“… The Court may ask what is a reasonable rate for the lender to charge. Or, the Court
may ask itself what is a reasonable rate of interest for the borrower to pay. In my view,
since the provision is about the reasonableness of the deduction of the interest payments
claimed by the borrower, the appropriate question is the latter. It should be pointed out
that, in the majority of situations, the answer to both of these questions would probably be
the same.” 48
Taxpayers entering into such transactions should seek the legal or tax advice with respect to the
deductibility of interest charges. (Refer to Section II - see (c); the amount must be reasonable). While the
comments were made with respect to an arrangement involving a policy loan, it would not be unexpected
to see CRA express similar concerns with respect to arrangements involving the collateralization of the
policy.
47
See Technical Interpretation 2004-0065531E5, dated December 6, 2004.
48
See Shell (FCA).
The Standard Life Assurance Company of Canada
August 2008
11

VIII. Summary
Taxpayers often incur debt in an attempt to leverage their position (i.e., maximize their returns). They
should first satisfy themselves as to the soundness of the investment or business transaction as a whole.
Whenever debt is incurred, a taxpayer should examine all aspects of the borrowing arrangement, and feel
comfortable with it. While debt can maximize returns, there is a downside potential as well – losses can be
magnified. Of course, whenever the taxpayer can realize tax savings on the borrowing charges, this serves
to enhance the returns.
This document is intended for general information only. It should not be construed as legal, accounting, tax
or specific investment advice. Clients should consult a professional advisor concerning their situations and
any specific investment matters. While reasonable steps have been taken to ensure that this information
was accurate as of the date hereof, The Standard Life Assurance Company of Canada and its affiliates
make no representation or warranty as to the accuracy of this information and assume no responsibility for
reliance upon it.
The Standard Life Assurance Company of Canada
August 2008
12