Tackle tax on bonds

A bond’s price will fluctuate based on the difference between its stated interest rate and that paid by a new bond issue with the same term to maturity. (Other factors, such as a change in an issuer’s credit rating, also can impact the price.) If a bond pays interest at a rate higher than what is offered by a new issue, its market price will be higher than the latter and it will trade at a premium to its par value. If you sell prior to the maturity date, this will result in a capital gain. Similarly, if the rate is lower, its price is at a discount, and if sold this will produce a capital loss.

Accrued interest and bond prices

A bond price also includes the amount of any accrued interest – interest that has been earned since the most recent payment date, but not yet paid out. As discussed below, the accrual amount does not form part of the capital gain.

Consider the example of a purchase of government bonds with a face value totalling $10,000 that pay semi-annual interest at an annual rate of 3% on June 30 and December 31 each year. Assuming the bonds are trading at a premium of $110, the price not including accrued interest would be $11,000. If the transaction takes place on July 31, the price would also include $25 in accrued interest, for a total price of $11,025.

In today’s environment of extremely low interest rates, longer term bonds that were issued when prevailing rates were higher are commanding higher prices than new or recent issues. Thus, a sale of many older bonds will result in a capital gain, while the acquisition of bonds in the secondary market may in fact give rise to a capital loss. In the above example where the bond is purchased at a premium, the amount paid, which includes the accrued interest up to the acquisition date, forms the investor’s adjusted cost base (ACB), which forms the starting point for calculating a capital gain or loss.

Impact on capital gains or losses

Once the accrued pre-acquisition interest is received, this would reduce the bond’s ACB. However, the interest coupon received would not be included in taxable income. “Post-acquisition, the investor is required to include the respective interest income on an accrual basis for tax purposes,” says Joseph Micallef, partner and National Tax Leader, Financial Services & Asset Management, with KMPG. “This accrual increases the ACB so that the investor is not double-taxed on any disposition prior to the bond’s maturity which may occur before the accrued interest is paid.”

“Thus, to the extent that the bond is sold prior to maturity and prior to the coupon payment date, this would prevent any interest income for tax purposes be erroneously characterized as being on included in the calculation of a capital gain or loss,” Micallef says.

Here’s an example of how the sale of a 2.75% bond maturing in 2025 would be taxed, based on the issue's current price. Assuming the original issue price for this bond was at a face value of $100 per unit, the current market value is $101.25, or an increase in value of $1.25 based on the price increase from the $100 par value at issue.

The bond’s coupons pay semi-annual simple interest of approximately 2.75%. Assuming the bonds were sold three months following the most recent coupon date, approximately 68.75 cents in interest per bond has been accrued, which would be reportable as income on your tax return. However, the investment’s ACB would be increased by that amount, raising the ACB to $100.69. The result is a capital gain of 56.24 cents per bond, of which one-half (28.12 cents) is taxable at your marginal income-tax rate.

Strip-bond taxation

Even more complex is the taxation of strip bonds. This is a bond that has been purchased by an investment dealer, which then removes the interest coupons. The principal portion (or strip) and the coupons are then sold as separate securities to clients.

A strip bond is purchased at a discount to its face value and the price increases the closer you get to the maturity date. The gradual increase in price is considered to be interest income, which must be reported on your tax return each year. To determine the amount of interest, the effective interest rate for each year of income must be calculated. This requires amortizing the discount over the period to maturity. While this is the responsibility of the taxpayer to calculate, this is normally calculated by your investment advisor.

A strip bond held to maturity will not generate a capital gain or loss—but this is not the case for a strip sold before maturity. A gain or loss will be calculated based on the difference between the proceeds of sales and the bond’s ACB. The amount of interest received (and reported) while the investment was held should be subtracted from the proceeds of the disposition, thus reducing the size of the capital gain.

“Strip bonds are like government treasury bills in that they pay no interest until maturity,” Micallef says. “Their prices depend on current interest rate levels and fluctuate from day to day. Until maturity, however, strip prices are always below par value ($100). The ‘interest’ earned is the difference between the ‘discounted’ purchase value and the stated maturity value.”

Regardless of how overall interest rates fluctuate in the interim, the rate of interest (or yield) earned is guaranteed as long as the strip bond is held to maturity. “Since there are no extra charges associated with a strip-bond transaction, the quoted yield is the actual compounded semi-annual (or annual, as the case may be) yield that you will earn throughout the life of the security if held to maturity,” Micallef says.

The Canada Revenue Agency deems that the difference between a strip bond’s purchase value and its maturity value constitutes accrued interest. Thus, outside an RRSP or other registered account, an annual interest value must be calculated and taxed accordingly, regardless of whether or not it has actually been received by the investor. However, if you sell the strip bond before it matures, you may have a capital gain or loss in addition to the interest accrued at that time.

“Before you calculate your capital gain or loss, you have to determine the amount of interest accumulated to the date of disposition.” Micallef says. “Subtract the interest from the proceeds of disposition and calculate the capital gain or loss in the usual way.”

Since interest income is taxed at a higher rate than capital gains, strip bonds are well suited to tax-deferred or tax-exempt accounts such as RRSPs or TFSA, he says.

Micallef offers the following CRA-published example of how interest from treasury bills or bond coupons is taxed:

Logan bought a T-bill on May 1, 2018 for $49,500. Its term was 91 days and its maturity value on August 1, 2018, was $50,000. However, he sold it on June 13, 2018, for $49,750. The effective yield rate was 4.05%.

He calculates interest on the T-bill that must be included in his income as follows:

• Purchase price multiplied by the effective yield rate times number of days T-bill was held, divided by the number of days in the year ($49,500 x 4.05% x 44 ÷ 365 = $241.67).

Logan calculates his capital gain as follows:

• Proceeds of disposition less interest equals the net proceeds of disposition ($49,750 − $241.67 = $49,508.33).
• Net proceeds of disposition less the adjusted cost base (ACB) equals the amount of capital gain ($49,508.33 − $49,500 = $8.33).