2 December 1981 Income Tax Severed Letter RCT-0780

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.

It is our position that the tax treatment for both the issuer and holder of what are generally known as deep discount bonds is essentially a question of fact. Based on our experience to date, it is necessary to examine all of the facts and documentation (especially the proposed debenture) in each particular case. This is not an unreasonable approach since the market for such debt instruments seems to be restricted.

The general position taken to date is as follows:

A. Zero Coupon Bonds - Issuer

• i) The original discount will if possible be treated as interest.
• ii) The deduction with respect to such interest will be computed on a compound interest method. To deduct such interest on a straight-line basis would normally result in an unreasonable amount. (This position is based more on commercial reality than on the debenture document itself.)
• iii) If requested on an advance ruling, we may confirm that the discount will be deductible as interest under 20(1)(c) using a compound interest method rather than having the simple interest deducted under 20(1)(c) and the compound interest deducted under 20(1)(d) (in the year paid). Since a debenture document is usually silent with respect to compound interest, it is possible to take an administrative practice that the compound interest method is a means of computing interest which is deductible under 20(1)(c) rather than computing an amount which would be partially deductible under 20(1)(d).
• iv) It is technically possible to take the position that the compound interest provision 20(1)(d) if strictly applied will severely limit the deduction available on the compound amount and provide the deduction only in the year paid. This possibility is not to be totally disregarded.

B. Low Coupon Rate Bonds

• i) Where the debenture bears a rate of interest, our general position is that the original discount will not be treated as interest but will be regarded as being payable on count of the principal amount of the debenture and thus, deductible when paid under the provisions of 20(1)(f). Of course, where the rate of interest is, say, 10% as opposed to 1%, our position is stronger. A legal opinion dated October 27, 1981 lends support to this position.

C. Tax Treatment of Holder

• In general the tax treatment of the holder should parallel that of the issuer. However, there would seem to be technical and legal difficulties in attempting to make this approach work. In particular 12(3) and the proposed amendments thereto and 20(14) may not integrate properly and the purchaser may make a different capital vs. income assumption that may have some legal support.

D. Example of Zero Coupon Bond

Coupon Rate          - 0 Term                - 10 years Principal           - 100 Issue Price         - 18  (Principal Amount per 248(1) definition) Discount            - 82 Yield               - 18%  - compounded semi-annually  Straight-Line       - 8.2   per year  - 45% of Principal Amount Simple Interest     - 3.24  per year  - l8% of Principal Amount  Compound Interest Method    % of                           % of                           Principal            Principal                              Amount              Amount   - year 1  - 3.4      - 20%               6  -  8.0  - 45%                        2  - 4.0                      7  -  9.5                        3  - 4.8                      8  - 11.2                        4  - 5.7                      9  - 13.4                        5  - 6.7              10  - 15.8  - 88%