19 December 2002 Internal T.I. 2002-0177317 - ACCRUAL NOTE

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the CRA.
Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'ARC.

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the CCRA.

Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'ADRC.

Principal Issues:

Information return reporting requirements for issuer of an accrual note.

Position TAKEN:

None. The Request does not include information that is essential to making a determination. General comments provided.

Reasons FOR POSITION TAKEN:

The security at issue appears to be an index-linked interest-bearing debt obligation such that it may be a prescribed debt obligation as defined in paragraph 7000(1)(d) of the Regulations. However, this derivative also appears to include a strippable coupon. In order to respond to the enquiry we require specific information concerning the security as well as the role of the author of the request in relation to the security (i.e. trader or dealer, an issuer, a nominee or other).

									December 19, 2002

	HEADQUARTERS						HEADQUARTERS
Assessment and Collection Branch				P. Diguer, CGA
Business Returns and Payments
Processing Directorate

Attention:  Louise Deslauriers
									2002-017731

Information return reporting requirements for issuer of an accrual note

This is in reply to your e-mail dated November 30, 2002 in which you request our views in regards to a request for information made in an e-mail received by you dated November 22, 2002 (the "Request"), which seeks to determine CCRA's view in regards to a particular taxpayer's obligation to make information returns (T5 and T5008) under Part II of the Income Tax Regulations (the "Regulations") in regards to interest paid on an accrual note.

We are unable to provide any opinion in respect of the accrual note as the Request does not include information that is essential to making a determination in regards to this matter including the terms and conditions of the interest on the accrual notes (note and coupon), the rights and obligations of the investor and issuer and the role of the author of the request in relation to the security (i.e. trader or dealer, an issuer, a nominee or other). Nevertheless, we have set out some general comments which we hope are of assistance to you.

The example set out in the Request to illustrate the author's views in regards to this matter appears to be incongruous with the interest-bearing debt obligation described therein. In this regard, the example illustrates, in simplified terms, the tax consequences to an individual that would flow where an interest-bearing obligation is purchased between its interest dates, has a principal amount and accrues simple interest. However, the type of security described in the Request is very different.

Type of Security

The term given the interest-bearing debt obligation in the Request is "accrual note". It is our understanding that an "accrual note" is a form of "index range note". Typically, an index range note is comprised of a note with a coupon on which the interest rate is determined largely or entirely by an embedded range accumulation option. Equity indexes, currency exchange rates and interest rates are among the underlying indexes, prices or rates that can determine the return to the investor.

Generally, an index-linked interest-bearing debt obligation which may include the accrual note described in the Request involves an investment in which the return is based in part on the return achieved by reference to a notional index such as the TSE 300, the S&P 500 or a specific stock or group of stocks. In such a case the note/ coupon holder owns no part of the stocks, currency, etc., that comprise the underlying index.

Prescribed Debt Obligation

Paragraph 7000(1)(d) of the Income Tax Regulations ("the Regulations"), describes a prescribed debt obligation as a particular debt obligation in respect of which the amount of interest to be paid in respect of any taxation year is, under the terms and conditions of the obligation, dependent on a contingency after the year.

As such, an accrual note held by an individual may be considered a prescribed debt obligation pursuant to paragraph 7000(1)(d) of the Regulations such that an amount of interest as calculated pursuant to paragraph 7000(2)(d) of the Regulations is deemed to accrue to the taxpayer for the purpose of subsection 12(9) of the Act.

The amount of interest deemed to accrue in each taxation year pursuant to paragraph 7000(2)(d) for a debt obligation described in paragraph 7000(1)(d) of the Regulation is the maximum amount of interest thereon that could be payable thereunder in respect of that year.

The issuer of a prescribed debt obligation of the type described above would be required to prepare a T5, Statement of Investment Income, for the deemed accrued amount pursuant to Regulation 201(4).

Strip

The accrual note is described in the request as being similar in nature to a strip bond, but with a principal amount. We believe that the use of the term "strip bond" is intended as a reference to "STRIPS" and as applied in this context is an acronym for Separately Traded Registered Interest and Principal Securities. For example, zero-coupon notes and bonds are created by trading note and bond coupon and principal payments stripped from Treasury securities. Each coupon is then sold separately at significant discounts to its face value. The certificate itself, now called the residue, representing the principal amount, is also sold separately. In effect it, too, becomes a zero coupon bond.

The reference to the accrual notes being similar to strip bonds in the request suggests that the individual interest payments and the principal payment at maturity on the note may be separated "stripped" and then sold separately.

Distinction between interest coupons attached to a debt obligation and stripped coupons is important as each coupon has a different reporting requirement.

In this regard, page 7 and 8 of the Revenue Canada 94-110 Handbook on Securities Transactions states that:

A stripped coupon, which a broker detaches from the bond and sells to an investor at a discount, is also a bearer coupon. However, when calculating income for tax purposes, the beneficial owner can deduct the cost of the coupon from the amount of the payment received. A broker generally holds stripped coupons in safekeeping and negotiates the stripped coupons on behalf of the beneficial owners. In the past, a T5 slip was commonly prepared to report any sales or redemptions of the stripped (bearer) coupons, since brokers usually carry stripped coupons in nominee name. This created an income reporting problem since the T5 would show the full amount of the payment received and some investors did not deduct the acquisition cost of the stripped coupon when calculating their income.

A financial institution that makes a payment in respect of a coupon cannot determine if the coupon has been detached from a bond by the bond owner (bearer coupon) or if the coupon has been separated from the residue and sold at a discount before it is cashed (stripped coupon). To resolve this problem, the Department has decided that any coupon an individual possesses is a bearer coupon, subject to the usual T600 or T5 reporting procedures. It is rare, although possible that a person will possess a stripped coupon. ...

Consequently, stripped coupons (coupons negotiated by an agent) will be reported on Form T5008 for 1993 and subsequent taxation years. Since the T5008 reports the proceeds of disposition or settlement amount and not interest income, this should resolve the problems associated with reporting stripped coupons.

(our emphasis added)

Conclusion

Reporting requirements of the financial institution that authored the Request where there is a sale and purchase of the accrual note between interest dates may only be determined once the financial institution's role (i.e. trader or dealer, an issuer, a nominee or other) is determined.

In summary, the author of the Request may, depending on the particular facts, be required to issue a T5 slip [Regulation 201(4)] and/ or a T5008 slip [Regulation 230(2), (3) or (6)] in regards to a payment that it makes in respect of a bearer coupon or a stripped coupon that has been detached from the accrual note, as the case may be.

We would be willing to consider this matter further in the event that the author of the Request provides the additional information.

For your information a copy of this memorandum will be severed using the Access to Information Act criteria and placed in the Canada Customs and Revenue Agency's electronic library. A severed copy will also be distributed to the commercial tax publishers for inclusion in their databases. The severing process will remove all material that is not subject to disclosure, including information that could disclose the identity of the taxpayer. Should your client request a copy of this memorandum, they can be provided with the electronic library version, or they may request a severed copy using the Privacy Act criteria which does not remove client identity. Requests for this latter version should be made by you to Mrs. Jackie Page at (819) 994-2898. A copy will be sent to you for delivery to the client.

Steve Tevlin
for Director
Financial Industries Division
Income Tax Rulings Directorate
Policy and Legislation Branch