28 August 1981 Income Tax Severed Letter

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.

R.C. Shultis 613-593-6937

August 28, 1981

Dear Sirs:

Re: Deep Discount/Deferred Payment Bonds

We are writing in reply to your letter of May 12, 1981 in which you requested our views with respect to the tax treatment to both the issuer and the purchaser of so-called "deep discount" or "deferred payment" bonds (the Bonds).

It is our understanding that these Bonds would be issued with a coupon rate substantially below the market rate at that time and then priced with an original issue discount in order to substitute a principal return component for the reduced coupon return to yield to an investor an interest rate over the term approximately equal to the market interest rate at the time of the issue.

Although the true nature of a discount must be ascertained from all the circumstances of each particular case as discussed in paragraph 3 of Interpretation Bulletin IT-114 , it is our opinion that it would be reasonable to regard the original discount on the issue of such a Bond as interest for both the issuer and the purchaser and that the original issue price would be regarded as the "principal amount" of the Bond as that term is defined in subsection 248(1) of the Income Tax Act (the Act). Accordingly, the provisions of paragraphs 18(1)(f) and 20(1)(f) and of subsection 16(3) would not apply on the issue of the Bond.

The purchaser of the Bond would be required to report the original discount as interest income pursuant to paragraph 12(1)(c) or sub- section 12(3) of the Act. That is, a corporation would recognize the original discount as being earned on a daily accrual basis and an individual would report the original discount on the cash, receivable, or accrual method as the case may be depending on the method regularly followed by the individual. In this respect, the comments contained in Interpretation Bulletin IT-396 relating to the reporting of interest income would be equally relevant to the reporting requirements for the original discount. If the purchaser transfers the Bond before maturity, subsection 20(14) of the Act would require him to report interest income in the year of transfer equal to the amount of original discount accrued to the date of transfer.

The issuing corporation, assuming it is not entitled to compute income on a cash basis, would be entitled to a deduction in respect of the original discount pursuant to paragraph 20(1)(c) of the Act equal to the portion of the original discount payable in respect of the particular taxation year. Such portion would be computed by amortizing the original discount over the life of the Bond on a straight-line amortization basis.

You have also requested our views as to the inter-relation of the rules at subsection 20(14) and the provisions of subdivision "C" of Division "B" of the Act where a purchaser transfers the Bond at a discount to a transferee prior to maturity and have put forth the following example to illustrate your understanding of the proper tax treatment.

EXAMPLE

Assume a $100 Bond is issued at a 0% coupon rate and priced to yield 15% with a term of 5 years. In such a case, the Bond would have the following characteristics:

 Face Value                  $100
 Coupon Interest               0% 
 Original Issue Discount  (51.48)
 Original Issue Price       48.52

Assume the Bond is purchased by an investor "A" (i.e., the transaction is neither part of a trade or business of "A" nor does it represent an adventure in the nature of trade) who includes interest income under paragraph 12(1)(c) on a receivable basis. The Bond is sold at the end of the second year of its term at a price discounted to yield 20% (the then prevailing rate) over the remaining three years until maturity. In such a case, the transferor would, in your view, report the following income for tax purposes in the year of the transfer:

Accrued Interest
to Time of Transfer
51.48 x 2/5                20.60 (rounded) 

Capital Gains (Losses)

Total proceeds received 56.45 (assumed amount) less

Proceeds on account of accrued interest (20.60)

Proceeds on account of principal amount 35.85

A.C.B.                   48.52

Gain (loss)             (12.67)

Allowable Capital Loss 6.34

Assuming the transferee, B, was likewise an investor computing interest income on a receivable basis, no account would be taken of the transfer until the year of maturity. In that year, you have concluded he would report the following income for tax purposes:

Interest Income

Original Issue Discount   51.48 
   less
Interest Included in 
A's incom per sub-
section 20(14)           (20.60)

Interest included
in B's income             30.88

Capital Gains

Total Proceeds Received   100.00 
   less
Proceeds on account of
Interest                  (51.48)

Proceeds on Account
of Principal Amont         48.52

Cost (price paid less price on account of interest)

(56.45 - 20.60 = 35.85) (35.85)

Capital gain (loss)         12.67 

Taxable Capital Gain         6.34

We confirm that the coupon interest of the Bond would be treated according to the usual rules while the original issue discount would be treated in the manner described in the foregoing example.

The above comments are opinions only and are not binding on the Department in any particular set of circumstances. In effect, the above confines and to a degree elaborates on the Department's position as outlined in Interpretation Bulletin IT-114 .

We trust that the foregoing will be of assistance toyou.

Yours truly,

for Director Specialty Corporations Rulings Division Corporate Rulings Directorate Legislation Branch