How Are Bonds Taxed?

A bond or debenture is a form of debt that pays interest periodically.  Depending on the type of bond or portion of the bond purchased, the tax treatment of the investment income may result in interest income, capital gains, or capital losses.

Interest Bearing Bonds

Bonds may be purchased in whole or in part:  For example, you may purchase a $10,000 bond that pays 5% interest annually.  If you hold the bond until maturity, you will receive a interest payment of $500 annually until maturity.  Upon maturity, you will receive back your $10,000.  On the other hand, bonds may be purchased in parts:

• Strip bonds – These are bonds what have had the interest payments “stripped” off and sold separately.  These bonds are purchased at a discount and held until they mature when you will receive the face value of the bond.  No interest “payments” are received by the holder.
• Strip coupons – These are the coupons “stripped” off the bond and are an entitlement to the interest payments.  The owner of strip coupons would receive the $500 interest payments per year in the example above, until the underlying bond matures.  The owner would not receive the face value of the bond on maturity.

Note that if you own any form of a bond inside an RRSP or RRIF there is no tax on the income received while the investment is inside the account.  You will only be taxed on the amount withdrawn from the account.

Taxation of Interest Paying Bonds

Interest paying bonds refers to the whole bond that is purchased.  When you purchase a bond you will be required to pay tax on the interest income you receive regardless of whether the bond is sold for more or less than face value (that is at a premium or a discount).  When you purchase a bond, the price will include any interest accrued but not paid since the last interest payment date.  When you receive the first interest payment, it will be for the whole amount and you will be able to deduct the interest included in the price from taxable income.

Capital Gains & Capital Losses on Bonds

As mentioned above, you may purchase a bond for more (premium) or less (discount) than the bonds face value which will result in a capital gain or capital loss if you hold the bond until maturity or sell the bond before maturity at an amount that is different than what you paid for it.

The capital gain or loss is the difference between what you received for the bond and what you originally paid for it. To determine if there is a capital gain or loss it is necessary first to determine the adjusted cost base (ACB).  The ACB of the bond purchased will be the total amount paid for the bond, less accrued interest included in the price and less any brokerage costs.

• If you purchased a bond at its face value and hold it to maturity or re-sell it at its face value, then there will be no capital gain or capital loss.
• If you purchase a bond at a premium, you are paying more for the bond than its face value and as such will incur a capital loss at maturity or if you sell it for less than you paid for it.
• Conversely, if you bought a bond at a discount, you will have a capital gain if you hold the bond to maturity or if you sell it for more than you paid for it.

Note that capital losses can only be used to reduce capital gains to zero and cannot be used against other forms of income.

How Are Strip Bonds Taxed?

Strip bonds held outside an RRSP can be difficult to report for tax purposes and require a fair degree of bookkeeping.

When a bond that has had its interest payments (or coupons) “stripped” off and sold to another investor the difference between the amount paid and the maturity value of the strip bond is divided over the number of years from time the strip bond is purchased until maturity and a portion is included in income as normal income each year.

A capital gain or loss may result if the strip bond is sold before maturity for an amount that is more or less than you paid for it.

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