Interest deductibility: what the borrowed money is used for

The same interest can be deductible for one owner and not another on identical loan terms. What decides it is not the lender, rate or security, but what the borrowed money was used for.

Interest deductibility, the rule in one sentence

The CRA’s guidance on business expenses is plain: you can deduct interest on money borrowed for business purposes or to acquire business property, but not on money borrowed for personal purposes or to pay overdue income taxes.

The detail is in Income Tax Folio S3-F6-C1. Among other requirements, the interest must be paid in the year or payable for it under a legal obligation, and be reasonable. The use of borrowed money must be established, and its purpose must be to earn income.

The direct use test

“Establish the use” is the whole exercise. The folio explains that the term use refers to the current use of the borrowed money, and in certain situations may include indirect use. Two consequences follow, and they surprise people:

• The security does not decide it. A loan secured by your home that funds business equipment is not automatically non-deductible, and a loan secured by business assets that funds a personal purchase is not deductible because of the security.
• First use is not final. If borrowed money is used to buy an income-earning property and that property is later sold with the proceeds put into another income-earning property, the current use of the borrowing follows the new property.

Refinancing and repayment

Refinancing does not reset the analysis; the current use of the money still governs. The reverse error is common: a partial repayment generally reduces the borrowing, and if part of it was non-deductible, the order in which the balance is treated as repaid matters.

The folio also describes the disappearing source rules, which can preserve deductibility when property bought with borrowed money is disposed of and the money can no longer be traced to an income-earning use. Several specific conditions apply.

The CRA treats a fee paid to lower a loan rate, or a penalty or bonus for repaying early, as prepaid interest deducted over the remaining original term.

Corporations, shareholders and the exceptions

For incorporated owners, two areas come up repeatedly. The first is borrowing by a corporation to redeem shares, return capital or pay dividends — the folio deals with this as an exception to the direct use test rather than as ordinary business borrowing, and the treatment depends on the circumstances.

The second is loans between the company and its owner. The folio says interest on money borrowed to make interest-free loans to employees, as employees, would generally be deductible, but not where the loans go to individuals as shareholders. If money moves between you and your company, the mechanics of shareholder loans matter as much as the interest.

Other limits worth knowing

The CRA also restricts interest on money borrowed for a passenger vehicle or zero-emission passenger vehicle, and on vacant land, where it is generally deductible only up to net income from the land. Capitalizing interest into property cost interacts with capital cost allowance, and a holding company adds a layer, since the borrower and income earner may differ.

The bottom line

Because deductibility follows the current use of borrowed money, how you borrow matters as much as what for. Keep business and personal borrowing separate, avoid commingling in one account, and document the purpose at the time. Refinancings, corporate distributions and owner-company loans are technical enough to review with a CPA on your facts before the transaction, not after claiming the interest.

This article is general information, current as of July 2026, not tax, legal or accounting advice, and creates no client relationship. Rules change and situations differ, so speak with a CPA before acting.