Interest income may not be in your best interest

National Post

2009-10-17


When it comes to tax-friendly income, interest has always taken a back seat to Canadian dividends or capital gains. After all, dividends received from Canadian companies benefit from federal and provincial dividend tax credits and capital gains are only half-taxable.

There are no such breaks for interest income.

Interest is fully taxable at your marginal tax rate thus making it the highest taxed form of investment income. It is therefore not surprising that a recent tax case dealt with whether certain amounts received by a Quebec taxpayer should be taxed as interest income or a capital gain.

During 2002 and 2003, Gerard Goulet purchased various notes and commercial paper at a discount on the secondary market. He held these investments for various periods, ranging from 27 to 90 days.

While the notes and paper themselves did not pay or accumulate interest, the actual rates of return on each investment was well known in the secondary market.

These debts were repaid by their respective issuers in 2003 and Mr. Goulet treated the roughly $30,000 difference between the redemption prices of the debt obligations and their purchase prices as capital gains.

The Canada Revenue Agency reassessed him and concluded that the difference between the redemption prices and the purchase prices was not a capital gain, and must be reported as interest income.

Mr. Goulet presented several arguments in court as to why he felt that capital gains treatment was appropriate, including the fact that his financial institution did not issue a T5 or any other information slip. He also argued that it was "very important to also consider the riskiness of these investments, which results in a higher rate of return." The fact that the debt was unsecured, Mr. Goulet argued, contributed to the discount upon issuance, so the returns should be considered capital gains and taxed as such.

The judge rejected Mr. Goulet's argument, turning to the Income Tax Act, which states that a taxpayer who holds a zero coupon bond must report and accrue interest on the debt using the "effective rate method." This method essentially uses the "constant rate," which equates the purchase price of the debt to the present value of its maturity amount, compounded at a minimum annually.

For example, if you bought a zero coupon bond on Jan. 1, 2009 for $85,000, which matured at $100,000 at the end of 2011, the effective annual yield would be 5.57% and your total interest over the three years would be $15,000. You would therefore report $4,732 of interest this year, $4,995 in 2010 and the balance of $5,273 in 2011.

Note that this tax treatment is not to be confused with the treatment of an ordinary bond.