Tax Court Revisits Issue of Interest Deductibility

Bank of Montreal v. His Majesty the King 2025 TCC 113

In the context of a Rule 58 Question, the Tax Court of Canada (“TCC”) was asked to decide a focused but consequential issue: could the Bank of Montreal (“BMO”) deduct interest it had paid to United States tax authorities on overdue federal and municipal income taxes for the years 1997–2001? The case turned on the interpretation of section 9 and subsection 18(1) of the Income Tax Act (“ITA”), which set the boundaries on what constitutes a deductible business expense.

BMO, a Canadian chartered bank with long-standing branch operations in the U.S., had dutifully filed its American tax returns and paid the balances it believed were due. Years later, however, the Internal Revenue Service (“IRS”) and the City of New York reassessed those filings, finding additional taxes owing. Alongside those reassessments came significant arrears interest: nearly $9 million in 2004 and an additional $1.8 million in 2006. When preparing its Canadian tax returns, BMO sought to deduct these interest payments as legitimate expenses incurred in the course of its business. The Minister disagreed, which necessitated this very litigation.

BMO advanced various arguments. Central to its case though was an analogy between arrears interest and refund interest. Canadian courts had previously held that interest paid by the government on tax refunds may, in some circumstances, constitute business income, as it stems from a taxpayer’s strategic decision to pay disputed amounts up front. By parity of reasoning, BMO contended, arrears interest should be deductible: it arose from the same decision-making process of how much to pay and when and in the face of uncertain liabilities.

BMO further argued that denying deductibility would amount to the Minister second-guessing its business judgment. It invoked the principle that the tax authority cannot substitute its own view of how a prudent businessperson should have allocated funds. Additionally, BMO pointed to provisions in the ITA—such as paragraph 18(1)(t) and subsections 20(11), (12), (12.1), and 126(2)—that expressly address the treatment of foreign taxes, suggesting that Parliament had already contemplated deductibility in certain contexts. According to the bank, if taxes themselves may attract a credit or deduction, then the interest tied to them should follow the same logic.

The Crown took the opposing view. Its primary submission rested on what is often called the Roenisch principle: expenses that arise after income has already been earned are not incurred “for the purpose of earning income” and thus cannot be deducted. In other words, arrears interest is not part of the income-generating process—it is a consequence of income having already been earned and taxed. The government also argued that allowing the deduction would distort the “most accurate picture” of the bank’s profits, which section 9 of the ITA requires. Since the underlying taxes were already excluded as deductible expenses, the related interest, being one step further removed, could not logically be treated more favourably.

Justice MacPhee carefully weighed both sides. He noted that the authorities cited by BMO, including Irving Oil and Munich Re, turned on very specific factual contexts where taxpayers had deliberately overpaid or prepaid disputed taxes as a business strategy. In contrast, BMO had simply paid what it thought it owed based on filed returns; the arrears interest only arose years later when audits revealed additional liabilities. That factual distinction was critical: the court found no evidence that BMO had made a conscious business decision to delay payment in pursuit of some income-earning objective.

Applying the Roenisch and Potash Corporation line of reasoning, the TCC concluded that arrears interest was not deductible. Such interest is inherently linked to the existence of taxable income and arises solely as a consequence of tax liability. Put plainly, without profit there is no tax, without tax there are no arrears, and without arrears there is no interest. The chain of causation demonstrated that the expense was not incurred to generate income, but rather to satisfy obligations after income had already been earned.

The TCC also dismissed BMO’s reliance on paragraph 18(1)(t) and related provisions. Justice MacPhee emphasized that section 126 provides relief from double taxation by allowing credits for foreign taxes paid, but that mechanism does not extend to interest on overdue amounts. Parliament’s silence on the deductibility of foreign tax interest was telling: the absence of explicit permission could not be read as an implicit endorsement.

Ultimately, the TCC answered the Rule 58 question in the negative. The arrears interest paid to U.S. tax authorities was not deductible under section 9 of the ITA and was specifically precluded by subsection 18(1). Costs were awarded to the Crown.

This decision underscores the careful line Canadian courts draw between business expenses that contribute to the earning of income and those that are merely consequences of income already earned. While the law may treat refund interest as taxable income in certain circumstances, the mirror image does not hold true for arrears interest. For businesses with international operations, the ruling is a cautionary reminder: interest on overdue foreign taxes cannot be shifted onto the Canadian tax base.