9 September 2003 External T.I. 2003-0006645 - CALLABLE STEP-UP BOND

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: Callable Step -up Bonds - are they prescribed?

Position TAKEN: YES

Reasons FOR POSITION TAKEN

									2003-000664
XXXXXXXXXX 								C. Tremblay, CMA
(613) 957-2139
September 9, 2003

Dear XXXXXXXXXX,

Re: Callable Step-Up Bonds

This is in reply to your letter of March 4, 2003, wherein you asked whether callable step-up bonds are subject to the yield to maturity calculations prescribed by paragraph 7000(2)(c.1) of the Income Tax Regulations (the "Regulations").

In our view, a callable step-up bond with features that include increasing interest rates throughout its term to maturity, and provides the issuer the ability to redeem the bond without penalty or premium at or prior to the day on which the interest rate would increase, is a prescribed debt obligation. Accordingly, the special rules contained in section 7000 of the Regulations and subsection 12(9) of the Income Tax Act (the "Act"), result in a deemed calculation of accrued interest for the purposes of subsection 12(4) of the Act.

In our view, a callable step-up bond is no different than any other step-up bond that has increasing interest rates throughout its term to maturity; the only risk being the unpredictable call date. Because of this feature, the holder is usually compensated by increased interest rates in the earlier year.

Neither the Act nor the Regulations contain a deeming provision that would consider a callable step-up bond to mature the next day on which the issuer is permitted to redeem it without penalty or premium. Callable step-up bonds are treated as having a maturity of their long date, that is, the maturity date that is listed as its term. The Canada Customs and Revenue Agency acknowledges that the holder does risk that the issuer will call the bonds if market interest rates decrease and in that event, the holder would not enjoy the interest rates stipulated on the instrument. However, there is also the possibility that the bonds may never be called before maturity if interest rates rise or remain stable.

Where the callable step-up bond is not held to maturity for whatever reason including being called by the issuer, or if the holder dies before maturity of the obligation, it is possible that interest income reported for income tax purposes will exceed the interest income actually paid. In such cases the excess interest income reported for tax purposes can be deducted under subsection 20(21) of the Act.

We have discussed your enquiry with officials from the Department of Finance who agree with our interpretation that a callable step-up bond is subject to the provisions of the accrued interest rules. Under the present wording of paragraph 7000(1)(c) of the Regulations, a callable step-up bond is a prescribed debt obligation. Any change to the rules regarding the determination of accrued interest in respect of callable step-up bonds would require an amendment to the Act or the Regulations. Should you wish to make submissions regarding such a change, you should write to the officials in the Tax Policy and Legislation Branch at the Department of Finance, L'Esplanade Laurier, 140 O'Connor Street, Ottawa, Ontario, K1A 0G5, who are responsible for amendments to the Act and the Regulations.

We trust that these comments will be of assistance.

Yours truly,

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