Interest deductibility: what the borrowed money is used for

Interest is one of the few expenses where the same dollar can be fully deductible for one owner and completely non-deductible for another, on identical loan terms. The difference is not the lender, the rate, or what secured the loan. It is what the borrowed money was used for.

The rule in one sentence

The CRA's guidance on business expenses puts it plainly: you can deduct interest incurred on money borrowed for business purposes or to acquire property for business purposes. It is equally plain on the other side — do not deduct interest on money borrowed for personal purposes, or to pay overdue income taxes.

The detailed position sits in Income Tax Folio S3-F6-C1. Alongside other requirements, the folio notes that the amount must be paid in the year or payable in respect of the year under a legal obligation to pay interest, and must be reasonable. Where money is borrowed, the use of the money must be established and the purpose of that use 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 continues to govern. This is also where a common error happens in reverse: when a loan is partly repaid, the repayment is generally treated as reducing the borrowing, and if some of the borrowing was non-deductible in use, the order in which the balance is treated as repaid matters.

The folio also describes the disappearing source rules, which can preserve deductibility where borrowed money ceases to be used for an income-earning purpose because the property was disposed of and the borrowed money can no longer be traced to any income-earning use. Several specific conditions have to be met for those rules to apply.

Separately, the CRA notes that a fee paid to reduce the interest rate on a loan, or a penalty or bonus charged to pay a loan off early, is treated as prepaid interest and deducted over the remaining original term of the loan rather than all at once.

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's position on interest-free loans is that a deduction would generally be allowed where borrowed money is used to make an interest-free loan to employees in their capacity as employees, but interest on money borrowed to make interest-free loans to individuals in their capacity as shareholders would generally not qualify. If money is moving between you and your company, the mechanics of shareholder loans matter as much as the interest question.

Other limits worth knowing

The CRA identifies specific restrictions, including limits on interest deductible on money borrowed to buy a passenger vehicle or a zero-emission passenger vehicle, and a limit for vacant land where interest is generally deductible only up to the income remaining from the land after other expenses. There are also rules on capitalising interest into the cost of property, which interacts with capital cost allowance. Structures involving a holding company add another layer, because the borrowing entity and the income-earning entity may not be the same.

The bottom line

Interest deductibility turns on the current use of borrowed money, which means the paperwork around how you borrow is as important as what you borrow for. Keep borrowings for business separate from personal ones, avoid commingling in a single account, and document the purpose at the time. Where a refinancing, a corporate distribution or a loan between you and your company is involved, the rules are technical enough that they should be reviewed with a CPA on your own facts before the transaction, not after the interest has been claimed.

This article is general information for Canadian business owners and is current as of July 2026. It is not tax, legal or accounting advice, and it does not create a client relationship. Tax rules change and your situation is unique — please speak with a CPA before acting on anything here.