ABOUT THE COURSE

Interest expense is one of the most frequently litigated areas in Canadian tax, and the gap between what par.20(1)(c) says and what the courts have decided is wide enough to produce genuinely surprising outcomes. A taxpayer who borrows money to acquire shares that later become worthless can continue deducting interest on the full original loan amount. A corporation that pays dividends out of retained earnings using borrowed money can deduct the interest. A trust that borrows to fund a capital distribution to a beneficiary cannot — even though the economic argument for deductibility is identical. The difference in each case is how the borrowed money is traced, and understanding that tracing is the core skill this course develops.

Part I covers the general rules for interest deductibility under par.20(1)(c):

• What is interest: compensation for the use of money, stated as a percentage of the principal sum, accruing day‑to‑day; why participating payments based on profit or revenue do not qualify as interest and the risk of double tax they create; the three conditions under which a participating payment may qualify as interest
• The four conditions of par.20(1)(c): paid or payable in the year; legal obligation to pay; reasonable amount; and used to earn income from business or property. The deduction is discretionary — unclaimed interest cannot be carried forward
• Barbican Properties: contingent interest tied to cash flow — deduction denied because the interest was neither paid nor payable in the year accrued; the alternative loan structuring that would have preserved the deduction
• Reasonable expectation of income (REOI) from Ludco: REOI must exist at the time the investment is made; it relates to gross income not net income; the expectation need not be the principal reason for making the investment; timing of income and interest expense do not need to match
• Direct use (Singleton): borrowed money directly traceable to an eligible income‑producing use is deductible regardless of other concurrent transactions; the distribution from a partnership used to buy a home is irrelevant where the bank loan directly funds a capital contribution to the partnership
• Indirect use: two theories — increased earning capacity (Canadian Helicopters) requires a bona fide purpose and reasonable expectation that income will exceed interest; fill‑the‑hole (Trans‑Prairie Pipelines, Penn Ventilator) allows deduction where debt replaces PUC or retained earnings used to fund the business; the contrast with Bronfman Trust where borrowing to make a capital distribution reduced earning capacity and did not fill any hole
• Notes issued to pay dividends vs. notes issued to redeem shares: Penn Ventilator permitted interest deduction on a note issued to redeem shares (the note replaced capital used in the business); Chase Manhattan denied deduction on a note issued to pay a dividend (the note did not acquire property or fill a hole)
• Current use: the current use of debt, not the original use, governs deductibility; the flexible approach (funds commingled, replacement property value equals or exceeds outstanding debt) allows favourable tracing; the proration approach (replacement property value is less than outstanding debt) requires pro‑rata allocation; worked examples with Darcy, Poppy, Sean, and Wayne
• Disappearing source under ss.20.1: when income‑producing property is sold for proceeds insufficient to repay the debt, the outstanding debt is deemed used to earn income on the remaining amount; applies to non‑depreciable capital property and ceased businesses; Tennant — interest deductible on full $1M loan even after shares dropped from $1M to $1,000 and were exchanged in a rollover; why real property held as capital and depreciable property are excluded from ss.20.1(1)
• Refinancing under ss.20(3): new borrowed money used to repay existing debt is deemed used for the same purpose as the original debt; applies to the interest deduction, financing expenses, disappearing source rules, and the s.21 election to capitalize interest
• Compound interest under ss.20(1)(d): must be paid in the year to be deductible; only on first‑level interest — compound interest on compound interest does not qualify; cannot be added to principal and treated as paid

Interest expense touches almost every file involving owner‑manager financing: real estate acquisitions, share redemptions, estate freezes, corporate reorganizations, and intercompany debt. Getting the analysis right requires knowing the case law as well as the statute — and this course covers both.