Bonds can be doubly taxing: Well behind pack for investment efficiency

National Post


With the Bank of Canada's decision earlier this week to hold interest rates
steady at 2.5%, it might come as a surprise that, despite the continuing low
interest rate environment, 2004 proved to be a banner year for bond issuance. In
fact, a report released last week by the Investment Dealers Association of
Canada pegged total bond issuance in 2004 at a record $165-billion, surpassing
the previous 2003 record by 12%.

Yet if you invest a significant portion of your portfolio in bonds, you'll
know that the low interest rates you've been receiving are further reduced by
the impact of taxation, with every dollar of interest income received fully
taxable at your marginal tax rate. As a result, interest income remains the
least tax-efficient form of investment income around, and places a distant third
to capital gains, taxable at only half your marginal rate and, in second place,
tax-advantaged Canadian dividends.

As a bond investor, however, you also need to be aware that if you're not
careful, you could be paying tax twice on your interest income. The culprit?
Something called accrued interest.

Most bonds pay interest income semi-annually. When you purchase a bond in the
bond market, chances are that you will not be buying that bond on one of the
interest payment dates, but rather at some point in between those dates.

Consequently, you are required to compensate the seller of the bond for the
interest earned from the last interest payment date to the date of purchase. For
example, let's say on March 1, 2005, you purchased a $100,000 bond with a 5%
coupon that pays interest semi-annually on June 1 and Dec. 1. In addition to
paying the purchase price of the bond, which could be trading at a discount or
premium, you must also pay accrued interest to the vendor from Dec. 1, 2004 (the
last interest payment date) to March 1, 2005 (the date of purchase). This is
equal to three months of interest or approximately $1,250 ($5,000 x 3/12).

On the next coupon date, June 1, 2005, you will receive the bond's
semi-annual interest payment of $2,500, which must be included in your 2005
income. But remember, you didn't really earn the full $2,500 since you only
purchased the bond on March 1. You are therefore entitled, under the Income Tax
Act, to deduct the accrued interest you paid when you bought the bond from your
income for the year. If you forget to do so, you are paying tax unnecessarily on
income you never earned.

A technical problem arises when you purchase a bond with accrued interest in
the last part of calendar year, but before the first interest payment from that
bond is received. For example, if you purchased a bond some time in December,
2004, and paid accrued interest to the vendor, the first coupon payment date may
not occur until some time in 2005.

Technically speaking, you're only allowed to deduct the accrued interest
purchased as an expense in the year you receive income from the bond -- in this
example, 2005. In practice, however, this rule is often ignored by investors who
receive a tax summary of all investment income and expenses from their broker at
year-end that totals all of the accrued interest they have paid on bonds
purchased during the previous year. Those investors simply take the total and
deduct it on their returns, without attempting to segregate the accrued interest
that specifically relates to bond interest income to be received in a future