How Interest-ing

Interest-bearing investments may be seeing a renewed popularity in the financial markets.

Perhaps this is because of the increased volatility the stock market seems to suffer at regular intervals, or that interest rates have crept up slightly from their lows not too long ago. At any “rate”, this new “interest” in debt obligations requires a brushing up on the tax issues surrounding these investments.

First of all, always remember that interest income is taxed the least favorably out of all the types of investment income when earned personally (and outside of a registered plan). There is no tax credit, as there is for dividend income, nor is there any reduction in the taxable portion, such as there is for capital gains. The full amount of interest income is annually taxed at the marginal tax rate of the individual investor. . . even if the earnings are compounding.

An example is the familiar Canada Savings Bonds. The interest on these investments must be reported each year whether it is received or not (i.e. accrues). The only exception to this rule is the Series 44 Canada Savings Bond, issued in 1989. This series still qualifies for the triennial reporting opti in which accrued interest is only reported every three years. The last three-year period for reporting the interest income from this series was 1998. Since the bond matures in 2001, there is no reporting requirement for the interest accrued in 1999.

All series subsequent to 44 must have the accrued interest income reported each year. A T5 slip is issued to holders of the bonds each year. The income reported on these slips must be reported on the tax return for that year.

Strip bonds are another type of compounding investment that must have the accrued interest reported each year. Since strip bonds are simply sold at a discount to their maturity value, the total return on these investments is the difference between the maturity value and the purchase price. Each year the investment is held, a notional interest amount must be calculated, and the amount reported as interest income on the tax return.

Mutual funds are still hot, hot, hot! For investors looking to participate in interest-bearing investments, a vast array of mutual funds that cater to this market exist. You will receive a slip from the mutual fund company reporting the amount of income to add onto your tax return for the year. The important thing to be kept in mind, however, is that even though a particular fund invests primarily in the bond market there may still be capital gains to report. If the fund manager realizes any capital gains from trading bonds, the investor’s proportionate share of these gains must be reported.