18 March 1993 Administrative Letter 9235556 F - Strip Bonds

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.

T2 & T3 Programs Division Financial Industries Division  Information Returns 

Attention:  W. S. Hume Director

Interest on Prescribed Debt Obligations

We are writing in response to your memorandum of November 26, 1992, requesting our comments on the schedules and calculations on the reporting of interest on prescribed debt obligations ("PDO"), primarily concerning accrued interest on strip coupons. We apologize for the delay.

Our Comments:

General Assumptions:

XXXXXXXXXX

Subsection 12(4) requires the taxpayer to include in income the interest that accrued up to the anniversary day of the PDO for that year. Subsection 12(9) simply deems an amount to accrue each year and provides for the timing and manner of recognizing accrued interest on the PDO as defined in subsection 7000(1) of the Regulations. Such accrued interest is determined in accordance with paragraph 7000(2)(b) of the Regulations. An individual cannot chose to report interest income as it is received or receivable. However, if for any reason additional interest than what has been calculated becomes received or receivable during the year, paragraph 12(1)(c) then becomes relevant.

For a stripped bond, the individual taxpayer must determine an amount which is deemed to be interest income in accordance with paragraph 7000(2)(b) of the Income Tax Regulations. The computation, which requires a specified interest rate, is then applied to the specified cost (present value) of each coupon and the aggregate of the amounts determined is the amount to be accrued as interest for purposes of subsection 12(4) of the Act.

Furthermore, subsection 12(9.1) of the Act ensures that when a coupon from a strip bond is paid or sold, the taxpayer receives recognition for the cost of the coupon in calculating his or her income.

XXXXXXXXXX

Example 1

XXXXXXXXXX, our review of the results obtained from the tables you have prepared, provide for an appropriate solution.

By using your Schedule B and following column 4 (to take in the 4 semi- annual periods) we arrive at 3.00 in the example given. We then used two more examples assuming the cost being $350 and $360 respectively to arrive at the interest rates 12.50%, 5.5%, and 4.25% to which we double to arrive at the yearly interest rates of 25%, 11%, and 8.50% respectively. The verification follows:

25% 11% 8.5%

Interest from Jan 1 to June 30, 1993 cost 300 x 25% x 182/365 = 37.39 350 x 11% x 182/365 = 19.19 360 x 8.5% x 182/365 = 15.25 Add to $ cost 300.00 350.00 360.00 337.39 369.19 375.25 Less coupon cashed 100.00 100.00 100.00 237.39 269.19 275.25 Interest from July 1, to Dec 31, 1993 237.39 x 25% x 183/365 = 29.76 269.19 x 11% x 183/365 = 14.85 275.25 x 8.5% x 183/365 = 11.73 267.15 284.04 286.98 less coupon cashed 100.00 100.00 100.00 167.15 184.04 186.98 Interest from Jan 1, to June 30, 1994 167.15 x 25% x 183/365 = 20.85 184.04 x 11% x 183/365 = 10.09 186.98 x 8.5% x 183/365 = 7.92 188.00 194.13 194.90 Less coupon cashed 100.00 100.00 100.00 88.00 94.13 94.90 Interest from July 1, to Dec. 31, 1994 88.00 x 25% x 183/365 = 11.03 94.13 x 11% x 183/365 = 5.19 94.90 x 8.5% x 183/365 = 4.05 99.03 99.32 98.95 Coupon cashed 100.00 100.00 100.00 difference because of rounding .97 .68 1.05

These interest calculations were prepared globally for verification purposes only. Each coupon, as you have shown in your examples, should be calculated separetely.

Example 2

XXXXXXXXXX

Example 3

Your example assumes the same numbers as in example 2 with the additional assumption that the taxpayer sells the fourth coupon on July 31, 1994 for 95.00. You have determined that the present value of the coupon on July 31, 1994, is $91.43. You seek our views on whether the transferor should report the difference as a capital gain or interest income. Similarly, if the coupon had been sold for $90.00, would a capital loss result? Our views are as follows:

According to subsection 12(4) and 12(9) of the Act and section 7000 of the Regulations, on the sale of a PDO prior to maturity, the seller is required to include in his income the amount deemed to accrue as interest in respect of the property to the time of sale except to the extent that it had previously been included in income. Moreover, subsection 20(14) of the Act requires a transferor of a debt obligation to include, in computing income for the taxation year during which the transfer occurs, the amount, if any, of the interest in respect of the obligation that has accrued prior to the date of the transfer and which was not, in accordance with the terms of the obligation, payable until after that date, to the extent that such interest was not otherwise included in income for the year or a previous year. The amount so included in income is added in computing the cost to the individual investor of that PDO by virtue of subsection 52(1) of the Act. On a sale of a strip coupon prior to its maturity date, a capital gain could result if the proceeds of disposition are greater than the adjusted cost base of the security (adjusted by any increase under subsection 52(1) of the Act). If the proceeds of disposition of a strip coupon are less than the adjusted cost base of the PDO (adjusted by any increase under subsection 52(1) of the Act), a capital loss will normally result. Accordingly, the differences of $3.57 and $1.43 would appear to be a capital gain and a capital loss respectively.

Director Financial Industries DivisionRulings DirectorateLegislative and Intergovernmental Affairs Branch