confused man

If you have clients who borrow to invest, you can bet they’re relying on the ability to write off interest on that loan come tax season.

If they borrow on margin or through a line of credit, there’s unlikely to be a concern with the quantum of interest paid, as the interest rate is probably commercially reasonable. But if investors borrow funds, either for the purpose of investing or for their business, from non-arm’s length parties, they should pay particularly close attention to the interest rate on the loan. If the Canada Revenue Agency deems the interest rate unreasonable, the CRA could take steps to challenge the deductibility of the interest paid.

That’s exactly what happened in a recent Quebec case. But before reviewing the details of the case, let’s review the general rule for deducting interest payments.

Under the Income Tax Act, investors who borrow money for the purpose of earning investment or business income can deduct the interest they pay on that debt for tax purposes. As discussed in my last column on TFSA maximizer schemes (which also dealt with interest deductibility), the Supreme Court of Canada has previously laid out the four requirements that must be met in order for interest to be tax deductible.

First, the amount must be paid (or payable) in the year. Second, it must be paid pursuant to a legal obligation to pay interest on borrowed money. In addition, the borrowed money must be used for the purpose of earning income from a business or property and, finally, the amount of interest paid must be reasonable.

But what exactly is a “reasonable” rate of interest? This question was the essence of the recent Quebec Court of Appeal case. The corporate taxpayer in the case operates one of the largest used car dealerships in Quebec. The dealership is owned by three brothers through their respective holding companies. To finance operations, the shareholders loaned $6 million to the dealership at an annual interest rate of 10%. The dealership paid interest on the loans and deducted the interest for Quebec provincial tax purposes.

Revenu Québec audited the corporate taxpayer and initially felt that the appropriate rate of interest to be used on the loan should be 3%, based on the Bank of Canada’s prime lending rate at the time.

The taxpayer argued that its 10% rate was reasonable, providing a letter from its bankers stating that the effective interest rate for financing unsecured vehicle inventories under cash flow deal loans was between 9–12%. The taxpayer also provided a report from Deloitte’s which concluded that a “reasonable rate” of interest for an equivalent loan would be between 7.89–12.39%.

Revenu Québec then reassessed the taxpayer on the basis that the correct rate to be used for the interest deduction was 7.89%, and the trial judge agreed. The taxpayer appealed this decision.

The appellate court reversed the lower court’s decision. The government’s position was that the interest rate of 10% was unreasonable. But since the taxpayer was able to provide two independent sources to back up its use of the 10% rate — namely, the bank and Deloitte reports — the court concluded that the taxpayer had “demolished” the government’s assumption that this rate was unreasonable and concluded that the interest expense was appropriately deductible.

As tax lawyer James Trougakos of Davies Ward Phillips & Vineberg LLP in Montreal wrote in a recent case note, “Given that reasonability often falls within a spectrum, tax authorities should not be permitted to reassess simply because they believe that a taxpayer’s deduction, while reasonable, could have been lower.”