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Strip Bonds

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Stocks, Bonds etc. -> Investing Tax Issues -> Strip bonds

Tax Treatment of Income From Investments in Non-Interest Paying Bonds (Strip Bonds)

Income Tax Act s. 12(4), 12(9), s. 12(11), s. 52(1)
Income Tax Regulations s. 7000(1)(b), s. 7000(2)(b)

The tax treatment information presented here is regarding bonds which are held outside of RRSPs or other registered accounts.

When a bond is issued, a brokerage company will buy bonds and will sometimes split them into two parts to sell separately.  One part is the interest payment (coupon), and the other part is the maturity value of the bonds, sold as strip bonds.  A strip bond is a bond that pays no interest.  It is purchased at a discount from face value, and face value is paid at maturity.

For tax purposes, strip bonds are treated differently from bonds for which interest payments are received.  The discount from maturity value is amortized over the period to maturity, and a portion is included in income each year as interest income.  Part years are pro-rated.  The adjusted cost base (ACB) of the bond will increase each year by the amount of the discount amortized.  At maturity, the ACB will be equal to maturity value, so there is no capital gain or loss.  A capital gain or loss can still be realized if the strip bond is sold prior to maturity.  The capital gain or loss is determined by deducting the ACB from the sales proceeds.

To determine the amount of interest income to accrue and include in income each year, the interest rate must be determined.  For example, assume a Canadian taxpayer purchased a strip bond with a maturity, or face, value of $10,000, on June 30, 2009.  The purchase price of the bond is $8,379.08, and the maturity date is December 31, 2013, in 4.5 years.  The interest rate used to calculate the annual interest income must be determined.  Our Present Value / Future Value Calculator can be used to determine the interest rate when a strip bond is purchased.  In this example, the "Find Rate of Return" column in the calculator is used:

  1. The purchase price of $8,379.08 is the present value

  2. The maturity value of $10,000 is the future value

  3. Compounding is annual, and

  4. Time period is 54 months (4.5 years)

This results in an interest rate of 4.01% in the calculator, which is actually slightly higher than the actual rate of 4%, due to the time period not being exactly 54 months..  The table below uses a rate of 4%.  If 4.01% were used, the ACB at the end of 2013 would be $10,004.34.  This would be resolved by reducing the 2013 income by $4.34.

 

Year ACB of strip
bond at start
of year
Annual
income
ACB at
end of year
2009 $8,379.08 $168.96 $8,548.04
2010 8,548.04 341.92 8,889.96
2011 8,889.96 355.60 9,245.56
2012 9,245.56 369.82 9,615.38
2013 9,615.38 384.62 10,000.00

In 2009, the starting ACB is the purchase price on June 30.  The annual income amount is $8,379.08 x 4% x 184/365 = $168.96, because the interest is accrued for the period July 1 to December 31 inclusive.

As you see, the ACB is increased each year by the amount of notional interest accrued to be included in taxable income.  The interest each year is calculated based on the ACB at the beginning of the year.

Interest is reported up to the anniversary day each year.  For instance, if the bond is purchased on March 31, and the anniversary day is June 30, only 3 months of interest would be reported for the year of purchase.  If the same bond was purchased on July 1, no interest would be reported for the year of purchase.  In the following year 12 months of interest income would be reported.  If the bond is not held to maturity, the date that the bond is sold is an anniversary day, and interest income for the year of sale would be reported up to that date.

See the Canada Revenue Agency (CRA) Technical Interpretation 2002-01231650 (pdf file) regarding annual taxation of interest on stripped bonds.

See also:

    Tax treatment of investments in interest-paying bonds

    Historical Investment Returns on Stocks, Bonds, T-Bills

Tax Tip:  Keep bonds (especially strip bonds) inside a registered account (RRSP, RRIF, TFSA, etc.).  They are not tax efficient, and the bookkeeping is complicated!  No bookkeeping is required when they are inside a registered account.

Revised: March 18, 2017

 

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