ongoing tracking of the use of borrowed funds

In an April 20, 2018 Tax Court of Canada case (Van Steenis vs. H.M.Q., 2017-3305(IT)I), at issue was whether the taxpayer could deduct interest incurred in 2013, 2014 and 2015 related to $300,000 borrowed in 2007 to purchase mutual funds. From 2007-2015, the taxpayer received a return of capital from the funds, totalling $196,850 over the period. The taxpayer used some proceeds to reduce the loan principal, but the majority was used for personal purposes.

impact of return of capital on interest deductibility

Taxpayer loses
To deduct interest paid on borrowed money used for the purpose of gaining or producing income from property (Paragraph 20(1)(c)):

• the amount must be paid or payable in the year;
• the amount must be paid under a legal obligation;
• the borrowed money must be used for earning non-exempt income from a business or property; and
• the amount must be reasonable.

The Court examined the third criterion noting that there must be a sufficient direct link between the borrowed money and the current use of the money to gain or produce income from property. As much of the returned capital was used for personal purposes, there was no longer a direct link to the income earning purpose. The Court dismissed the appeal and upheld CRA’s denial of interest expense.