Taxation of strip bonds and strip bond packages
There are two basic approaches to taxation of strip bonds and strip bond packages - taxation of the change in market value each year (e.g., the U.K.) and taxation of the accrued interest, based on the original discount (e.g., Canada and the U.S.).
For taxation in the U.S., see relevant U.S. government sites such as Publication 550 - Investment Income and Expenses and List of Original Issue Discount Instruments.
For taxation in the U.K., see relevant U.K. government sites such as the announcement of changes in 2004 and Inland Revenue document on strips for some background information.
For taxation in India, see Income Tax Department, India. For all countries, I recommend that you consult a qualified tax advisor.
The information below applies to Canada only.
According to the Investment Dealers Association of Canada,
The Canadian income tax consequences of purchasing strip bonds and strip bond packages are complex. Purchasers of strip bonds and strip bond packages should consult their own tax advisors for advice relating to their particular circumstances. The following summary is intended to be a general commentary on the attributes of strip bonds and strip bond packages under the Income Tax Act (Canada) ("Tax Act") and the regulations thereunder ("Regulations") for purchasers who hold their strip bonds and strip bond packages as capital property for purposes of the Tax Act.
The following comments are based on Canadian practices only, as described in the Investment Dealers Association of Canada's Strip Bond and Strip Bond Packages Information Statement dated June 2003. The information was updated based on publications available on the Canada Revenue Agency web site (www.cra-arc.gc.ca)
.Eligibility for Registered Savings Plans
Strip bonds and strip bond packages are "qualified investments" that may be held within Registered Retirement Savings Plans ("RRSPs"), Registered Retirement Income Funds ("RRIFs", and Deferred Profit Sharing Plans ("DPSPs").
Annual taxation
Purchasers of strip bonds (other than non-taxable accounts such as registered savings/income plans, pension funds, and charities) are required to include in income in each year an amount of interest, representing the return earned during the year. (This is similar to the treatment of Guaranteed Investment Certificates and Canada Savings Bonds with compounding interest, where the investor also pays the tax before any interest is actually received in cash.)
Generally, in Canada, investors use the net yield (based on the cost including commission and other fees) expected on their investment if they hold it to maturity, with compounding at least annually.
NOTE: Holders of indexed strip bonds (such as the real return strip bonds) should consult a professional tax advisor for guidance on what to report, since the amount received at maturity will not be known until shortly before the maturity date. The same problem also applies to strip bonds that are payable in a foreign currency, as the payment amounts should be converted into the investor's domestic currency for tax reporting purposes. Since the future payment amounts depend on the exchange rate in effect on each future payment date, you should consult a tax advisor as to how to handle the calculation.
For individual investors in Canada, there are two ways to calculate the required accrual. One is based on the anniversary date of the issuance of the underlying bond. The other is for the full taxation year. Since the overwhelming majority of strip bonds (both interest and principal components) use generic security numbers (i.e. the same security number for all strip bonds having the same issuer, payment date, payment currency, and no distinguishing features), it is often impossible to identify the underlying bond for the strip bond. This is particularly true in Canada due to the broader use of generic strip bond security identification numbers.
NOTE: The current regulations in Canada also do not contemplate the possibility that the underlying bond may change from year to year, as dealers may strip another bond having the same issuer and payment dates and then use those strip bonds to reconstitute the original underlying bond.)
Because of these factors, it usually will be much simpler for individual investors to use the taxation year. When doing this calculation for the first year, you count the number of calendar days from the settlement date of the purchase (i.e., the date on which your account at the investment dealer was debited for the purchase cost) to the end of the taxation year. (Do not count the settlement date itself.)
Corporations, partnerships, unit trusts and any trust for which a corporation or partnership is a beneficiary are required to report accrued notional interest for the full taxation year.
Sale of strip bonds prior to maturity
When a Canadian investor sells a strip bond prior to maturity, he/she is required to include the interest income accrued on the strip bond during the year up to the settlement date (the date on which you are entitled to receive the sale proceeds) of the sale.
If the amount received from the sale exceeds the total of the purchase price (including commissions and other charges) and the amount of all interest accrued (since you bought the strip bond) and included in income, the excess may be treated as a capital gain (if you have elected to do so). Similarly, if the amount received from the sale is less than the total of the purchase price and all of the accrued interest included in income, the difference may be treated as a capital loss.
Only 50% of the capital gain is included in your taxable income. Only 50% of capital loss may be deducted from any taxable capital gains you included in your income.
Annual taxation on strip bond packages
Because a strip bond package consists of a series of separate strip bonds, theoretically you could calculate the interest to be accrued for each individual strip bond included in the package. However, that could become very complex and require a lot of additional information on strip bond prices that is not readily available to most investors.
The more practical approach is to accrue interest based on the yield for the strip bond package as a whole, assuming that the package will be held to the final maturity date. This calculation can be complex, depending on the specific cash flows associated with the package, particularly for multiple rate packages. For packages including indexed strip bonds (e.g., real return strip bonds), investors should seek professional advice, since the final payment amounts are not fixed at the time of the purchase. The same problem also applies to strip bond packages that are payable in a foreign currency, as the payment amounts should be converted into Canadian funds for tax reporting purposes. Since the future payment amounts depend on the exchange rate in effect on each future payment date, you should consult a tax advisor as to how to handle the calculation.
Sales of strip bond packages
When you sell a strip bond package prior to maturity, you are required to include the interest income accrued on the strip bond package during the year up to the settlement date (the date on which you are entitled to receive the sale proceeds) of the sale.
If the amount received from the sale exceeds the total of the purchase price (including commissions and other charges) and the amount of all interest accrued (since you bought the strip bond) and included in income, the excess may be treated as a capital gain (if you have elected to do so). Similarly, if the amount received from the sale is less than the total of the purchase price and all of the accrued interest included in income, the difference may be treated as a capital loss.
Only 50% of the capital gain is included in your taxable income. Only 50% of capital loss may be deducted from any taxable capital gains you included in your income.
Non-residents of Canada
In general, non-residents of Canada who purchase strip bonds or strip bond packages relating to underlying bonds issued by a Canadian issuer are not liable for income tax in Canada if the securities are not used for carrying on business in Canada and the purchase and ownership of these securities is their only connection to Canada.
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