Folder tab with the word tax

Investors who borrow money for the purpose of earning investment income can generally write off the interest paid on such debt. But what if the investment turns out to be a dud and goes to zero, yet the investor still owes money on the loan? Should interest continue to be deductible for tax purposes long after the original source of that income has disappeared?

The answer, fortunately, comes in the form of a little-known rule in our Income Tax Act sometimes known as the “loss of source” rule. The rule, which has been in force since 1994, applies when a borrower ceases to use the borrowed money for the purpose of earning income when the source of income disappears. The rule, therefore, essentially permits an investor to continue to write off otherwise deductible interest expense, even after the source of the investment income has disappeared. It also allows business owners who obtained a loan for their now-defunct business to do the same.

I’ve often referred to this rule in the investing context as the “Bre-X rule,” named after the infamous mining company that went bust. For example, let’s say you had borrowed funds back in the mid ’90s to buy shares of Bre-X. The company, which started out as a penny stock and peaked at close to $300, went bankrupt in 1997 after a massive fraud involving falsified gold samples was unveiled. Well, the good news is that if you had borrowed to invest in Bre-X shares and that loan were still outstanding today, you could continue to write off your interest expense, as the funds were originally borrowed for the purpose of earning investment income.

The loss of source rule as it pertains to a business was recently tested in Tax Court in a case involving an accountant who deducted interest expense on his 2013 and 2014 tax returns. From 2002 to 2007, the taxpayer was self-employed and carried on an accounting practice. In the years under review by the Canada Revenue Agency (CRA), the taxpayer was employed as a lecturer at several universities.

The interest expense for the years in question arose from a variety of expenses that the taxpayer had incurred for his business back in the 2002 through 2006 taxation years. These business expenses were all paid for by cheques drawn on his home equity line of credit (“HELOC”), which was used exclusively for business purposes. After this date, the HELOC was used solely to repay the interest charged by the bank.

The taxpayer ended up in Tax Court because the CRA denied the interest expense he claimed in 2013 and 2014. The taxpayer argued that he should be entitled to continue to deduct the interest expense on the loan even though the business had ceased operating, since the loan subsisted and interest continued to be paid. He argued that under the loss of source rule, “the borrowed money is deemed to be used by the taxpayer for the purpose of earning income from the business, and that this (rule) therefore allows for the deduction of interest paid on borrowed money.”

The judge turned to the loss of source rule, which clearly provides that the portion of the borrowed money outstanding when a business ceases operating “shall be deemed to be used by the taxpayer at any subsequent time for the purpose of earning income from the business.”

The judge therefore concluded that the conditions for the application of the loss of source rule were met and therefore, the borrowed money that was outstanding when the taxpayer’s business ceased operating “shall be deemed to have been used by the (taxpayer) in the 2013 and 2014 taxation years for the purpose of earning income from the business.”

As a result, the taxpayer was entitled to deduct 100% of the interest expense he claimed for the 2013 and 2014 taxation years.