Regulation 7000 - Accrued Interest on Debt Obligations

The interest accrual rules for prescribed debt obligations generally will not apply to debt obligations (in this case, undivided interests in wholesale receivables sold to investors and payable on a floating interest rate basis) that pay a floating rate of interest to an investor on a monthly basis.

Regarding whether the proportions referred to in Reg. 7000(1)(b) are determined by reference to the specific taxpayer and not on all taxpayers who held the bond. CCRA stated:

[T]he proportions referred to in paragraph 7000(1)(b) … should be determined, for a specific taxpayer, by considering all payments that the issuer of the obligation is required to make after that taxpayer has acquired the obligation. Consequently, a second holder of a bond will not automatically be subject to the rules in paragraph 7000(1)(b) … solely because that holder was not entitled to receive the interest payable under the bond before acquiring it from the first holder.

An individual acquired a bond, bearing interest at 7% and with a face value of $100, for investment purposes in the secondary market for $124. What is the treatment of the $24 premium? CRA stated:

[A]n obligation such as the one described in the above example is not an obligation described in paragraph 7000(1)(b) … .

A stripped bond is a prescribed debt obligation under s. 7000(1)(b).

A taxpayer who acquires a bond whose interest coupons for the first ten years previously were stripped and sold separately will be required to accrue interest calculated in the manner prescribed by Regulation 7000(2)(b). When an interest coupon matures, the portion of the proceeds of disposition that reasonably may be considered to represent a recovery of the cost to the taxpayer is not included in income.

Both strip bonds and interest coupons which have been removed from them are prescribed debt obligations. When an interest coupon matures, the proceeds of disposition which represent a recovery of the cost need not be included in income.

In response to a query as to whether callable step-up bonds are subject to the yield-to-maturity calculations in Reg. 7000(2)(c.1), CRA stated:

[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 [under Reg. 7000(1)(c)]. …

[A] callable step-up bond is no different than any other step-up bond that has increasing interest rates throughout its term to maturity… .

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…that is, the maturity date that is listed as its term. …

[T]he excess interest income reported for tax purposes can be deducted under subsection 20(21).. .

CCRA confirmed that its position in 5-963476 regarding the exclusion from the application of Reg. 7000 of certain debt securities was only applicable to certain slightly rising interest debt securities issued before 1997. It then stated:

In the case of a prescribed debt obligation described in paragraph 7000(1)(c) … i.e., in respect of which the greatest amount of interest payable in a year may be less than the greatest amount of interest payable in a subsequent year, the interest is calculated under paragraph 7000(2)(c) or (c.1) … as the case may be. Paragraph 7000(2)(c.1) applies if the interest rate for each period is fixed at the date of issue of the debt and if the interest rate does not decrease.

"It is our position that an interest in an obligation which is issued at a discount and carries a stipulated rate of interest is not a prescribed debt obligation under subsection 7000(1) of the Income Tax Regulations ... . The determination of whether or not a true discount represents interest could not be made without knowing the nature or the activities and the legal obligations of both parties to a transaction ... ."

Although a note payable for property acquired that has a contingent interest payment based on an unknown amount would be a prescribed debt obligation under Regulation 7000(1)(d), because the amount of the interest that could be payable in respect of the current year cannot be calculated before the principal payment date, no information return is required to be filed under Regulation 201(4), and no amount is included in income under s. 12(4).

Canco advances the Loan to a related charitable foundation. The Loan is not issued at a discount and matures in X years. Are there any tax consequence to Canco to the Loan not bearing interest? CRA stated:

Where the cost of the Loan is less than the amount payable at maturity, there will be a deemed accrual under paragraph 7000(2)(a) of the Regulations. However, because the Loan was made between two non-arm's length parties, paragraph 69(1)(a)… may apply to reduce the cost of the Loan to Canco. If the Loan is not repayable at the demand of Canco, it is possible that the fair market value of the Loan could be less than the amount advanced by Canco under the Loan. If that is the case, then paragraph 69(1)(a)… could deem Canco to have acquired the Loan at a cost equal to the fair market value of the Loan, triggering the deemed accrual under paragraph 7000(2)(a)… .

In the course of the general discussion of the application of Reg. 7000(2)(b) to the acquisition of the principal component of a stripped bond, CCRA stated:

The calculation of interest prescribed in paragraph 7000(2)(b) of the Regulations requires the determination of the “specified interest rate” which when applied to the “specified cost” gives the amount that must be included in income for the purposes of subsection 12(4) of the Act. The “specified interest rate” is a single rate, calculated using assumptions concerning the interest rate and compounding period (compounded annually). That rate, when applied to the payment under the debt obligation, will result in a present value which corresponds to its purchase price. The “specified cost” is equal to the acquisition cost of the stripped bond.

If a taxpayer holds the bond residual (without coupons) to maturity, the difference between the bond's proceeds of disposition and its ACB must be included in the taxpayer's income as interest, following the rules set out above.

A capital gain or loss may still be realized on the disposition of such a bond if it is sold before maturity. However, the deemed accrued interest must be calculated pursuant to paragraph 7000(2)(b) of the Regulations and included in income before determining the amount of the capital gain or loss realized on such disposition.

How is interest on increasing-rate debt securities computed under Reg. 7000(2)(c) or (c.1) where the rate of interest payable is not specified for at least one period of their term or may be adjusted upwards at the discretion of the issuer? CRA responded:

In making the calculation pursuant to subparagraph 7000(2)(c)(ii) and paragraph 7000(2)(c.1) of the Regulations, we are of the view that the issuer should make this calculation annually based on the known interest rates at the time of the calculation. Where a security specifies a minimum rate for each year of its term, the calculation of the amount should be made taking into account the known maximum rates. For years where the maximum rate is not yet known, the minimum rate should be used to make the calculation. In a situation where the debt instrument does not specify an interest rate for certain periods, the amount should be calculated taking into account the known rates and assuming that the rate for periods where no rate is specified is nil.

A $1,000 escalating-rate investment certificate (that is an "investment contract") with a three-year term was issued to an individual on January 1 of a particular year. It bears interest, payable annually, at a rate of 6% in the first year (Year 1), 8% in the second year (Year 2) and 10% in the third year (Year 3). CRA stated:

[T]he "anniversary day" would be December 31 since that day is one year after the day before the date the contract was issued (the date of issue). Since the individual would hold an interest in the investment certificate on December 31 of Year 1, the individual would be required by subsection 12(4) to include in computing income for that year the interest accrued to the individual on the investment certificate to the end of that day to the extent that such interest was not otherwise included in computing the individual's income for the year or a preceding taxation year. The same logic would apply for Year 2 and/or Year 3.

Interest on an escalating term deposit would be reported on a yield-to-maturity basis.

Ruling respecting a stock-linked note where no return (other than in extraordinary circumstances) was payable until maturity, that so long as any variable return early payment amount does not become payable before the year in which the final valuation date occurs, no amount will be required to be included under s. 12(4) in the income of an individual note holder, and that the variable return will be required to be included under s. 12(1)(c) on maturity.

A bank GIC has a 3 year term, interest is calculated by reference to an increase in the value of a particular stock or stock index with no guaranteed annual interest, and with interest paid at maturity. Can the interest be apportioned over the three year term? CRA responded:

An equity-linked investment by an individual such as the one described in your letter is generally considered a prescribed debt obligation pursuant to paragraph 7000(1)(d) of the Regulations such that an amount of interest is calculated pursuant to paragraph 7000(2)(d)… . [S]ince the return on the equity-linked investment held by an individual as described in your letter was not known until the maturity date, no amount could be deemed to accrue under the rules set out in paragraph 7000(2)(d)…until the maturity date. Accordingly, the entire return on the investment is calculated and reported for income tax purposes in the taxation year into which such maturity date falls. There is no provision…[to] permit the interest amount…to be apportioned over multiple taxation years.

The amount payable on maturity on a stock-index linked GIC (which is deemed to be interest by Regulation 7000(3)) does not require any recognition of income in years prior to the year of maturity because "the maximum amount of interest that could be payable in the year with regard to the deeming provision in subsection 7000(3) of the Regulation is unknown". In the year of maturity, the full amount of the index-linked return is the maximum amount of interest that could be payable under the GIC for that year for purposes of Regulation 7000(2)(d).

The return on an index-linked note is capped at 90% of the principal amount. A representation is made that "the Return that the Holder can expect to receive on the Notes is indeterminable being an amount between 0% and 90% (inclusive) of the Principal Amount." Ruling that no amount will be required to be included in the Holder's income under s. 12(4) during the term of the Notes.