Beware the premium tax on bonds

National Post


Do bonds play an important role in your portfolio? If so, you need to pay
special attention to the tax treatment when buying and selling a bond -- because
you could find yourself at a significant tax disadvantage when the bond matures.

Bonds often trade at a discount or premium to their principal value. This
happens if the coupon rate on the bond is either lower than prevailing market
interest rates for the period to the bond's maturity (providing the bond
discount), or higher than the prevailing rate to maturity (giving the bond a
premium). For example, at the time of writing, a Government of Canada bond
maturing in 2014 with a stated rate of 5% was trading at 105.45, producing an
effective yield of about 4.28%.

Although the effective yield takes into account both the stated interest that
will be paid semi-annually and the premium paid, for tax purposes the discount
or premium is not amortized into income over the period the bond is being held,
but rather gives rise to a capital gain or loss upon the ultimate sale of the
bond or upon its maturity.

So, if you purchase a bond at a discount, at maturity you will realize a
capital gain equal to the difference between price paid for the bond and its
face value. Conversely, if you purchase the bond at a premium, at maturity you
will have a capital loss equal to the bond's face value less the price paid.

For example, if you had purchased the $100,000 Government of Canada bond
above, paying $105,450, you would receive and pay tax on $5,000 of interest
annually, but be entitled to claim a capital loss of $5,450 in 2014 when the
bond matures.

A more accurate way to calculate your annual income from the bond investment
might be to amortize the $5,450 premium paid over the term of the bond. Assuming
there are approximately 10 years left until the bond matures, you would deduct
1/10 of the premium or $545 from the $5,000 annual payment and report only the
net amount each year.

Unfortunately, the tax rules do not allow for amortization of the bond
premium, which leads to three problems. The first and most obvious one is
timing: You report more taxable interest income each year than you will
ultimately receive taking into account the premium you paid upfront, and not get
a deduction for that premium until the bond matures (or until you sell it).

Secondly, the interest income reported annually is taxable in full at your
marginal tax rate, whereas the ultimate $5,450 loss is a capital loss and is
only 50% deductible, not affording you equal treatment.

Thirdly, and perhaps most problematic, is that because the loss is a capital
loss, it may only be used to offset other capital gains. If you have no capital
gains in the year the bond matures (or the year you sell it), you can carry that
capital loss back three years to offset gains in those years or carry it forward

In other words, unless you plan to realize some capital gains in the future
from the sale of other properties, you may be unable to utilize the capital loss
for some time.