Real Return Bonds are Government of Canada bonds that pay interest based on changes in the Consumer Price Index (CPI). In other words, the interest you receive on these bonds changes with the rate of inflation. However, the income tax is not straightforward!
The Mechanics of Real Return Bonds
With a regular bond, the redemption value, or value you receive at maturity is known. For example, a $10,000 5% bond will pay you annual payments of 5% and you will get the principal of $10,000 back at maturity.
Real return bonds are issued at par and the redemption value changes with annual changes in CPI. For example, a real return bond is issued at $1,000 with a 5% coupon paid semi-annually. At the end of the first 6 months, CPI has increased 1.5%. Therefore, the base value of the bond is now $1,015 and the semi-annual interest payment will be 2.5% of $1,015.
The annual interest (coupon) payments received change with CPI and the value of the bond at redemption increases with the general rate of inflation.
Tax Issues With Real Return Bonds
The actual cash interest you receive semi-annually is taxable in the year received (or receivable depending on your method of accounting). The annual change in the base value of the bond is considered interest income and taxed annually.
A real return bond issued and purchased on January 1st at $1,000 with a 5% coupon rate paid semi-annually. The bond paid interest of $25.38 after the first 6 months and $25.50 after the second 6 months. The ending value of the bond with the CPI adjustment is $1,020.
The tax payer reports interest income of $70.88 which is comprised of:
- The 2 cash payments of interest of $50.88 ($25.38 + $25.50), and
- The change in the CPI adjustment of the bond of $20.00.
Where To Hold Real Return Bonds
If you want to avoid the headache of reporting the annual interest on real return bonds, consider holding them inside your RRSP, RRIF, or your TFSA. Interest income is not as tax efficient as other forms of investment income and is best held in tax-deferred accounts.