Interest charges are deductible if the borrowed money is used to earn income from a business or property (for more details, click here). The courts have ruled that the borrowed money must be used directly, not indirectly. We explain the nuance of borrowing.
What is direct and indirect use?
To understand the difference between direct and indirect use, let’s look at the following example.
Example
- You have $40,000 in liquid assets.
- You would like to purchase $40,000 worth of mutual fund units, and
- Consider buying a $40,000 automobile for personal use.
If you borrow $40,000 to buy a car, the direct use of the borrowed money is not the generation of income. You cannot successfully argue that the loan indirectly enabled you to purchase the mutual fund units. That is, the loan allowed you to use your $40,000 in cash to purchase the mutual fund units. Interest on the loan is not deductible.
If, on the other hand, you borrow $40,000 to purchase mutual fund units, the direct use of the borrowed money is to generate income. You can then use your $40,000 in cash to buy the car. Obviously, this makes more sense, since the interest on the loan would then be deductible.
The advantages of direct use
The direct use rule offers some tax-planning possibilities and opportunities, especially when you own a few income-producing assets and are considering borrowing for personal use. You can liquidate some of the assets, use the money for personal purposes and then borrow to acquire the assets again.
A concrete example
Let’s say you already own $40,000 worth of mutual funds and are considering borrowing to purchase a $40,000 personal automobile. You could sell the mutual fund units, use the $40,000 proceeds to buy the car, then borrow to buy back the units. In this case, the direct use of the loan would be an income-generating activity, and the interest on the loan would be deductible. (This plan is most effective if the mutual fund units have little or no accumulated capital gain. This is because the gain will materialize when you sell the units). This type of tax planning has been approved by the courts, most notably by the Supreme Court of Canada in the 2001 Singleton decision.
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