Principal Issues: [TaxInterpretations translation] Does a penalty on redemption of a bond reduce the interest income of the bondholder?
Position: No
Reasons: The penalty arises and relates to the redemption of the bond. It may be taken into account in computing the gain or loss on capital account arising from the disposition of the bond.
XXXXXXXXXX 2007-022883 Michel Lambert CA, M.Fisc. June 7, 2007
Dear Sir,
Subject: Bond penalty
This is further to your fax of March 27, 2007, asking about the tax treatment of a penalty on an early bond repayment.
Unless otherwise indicated, all statutory references herein are to provisions of the Income Tax Act (the "Act").
As stated in paragraph 22 of Information Circular 70-6R5 dated May 17, 2002, it is our practice not to issue written opinions on proposed transactions otherwise than by way of advance rulings. Furthermore, when it comes to determining whether a completed transaction has received appropriate tax treatment, that determination is made first by our Tax Services Offices as a result of their review of all facts and documents, which is usually performed as part of an audit engagement. However, we can offer the following general comments that we hope may be helpful to you. These comments may, however, under certain circumstances, not apply to your particular situation.
You have presented us with a situation in which the holder of a bond requests the redemption of its bond before maturity, even though, according to the terms of the bond, such redemption was not permitted. You agree to redeem the bond but demand a penalty, the method of calculation of which is determined in accordance with order number 10 of the Quebec Minister of Finance, which reads as follows: [TaxInterpretations translation]
Bonds are redeemable at the owner's request on or after the second anniversary of the date of purchase by applying a penalty to the redemption which consists of withholding a portion of the interest accrued since purchase, whether or not such interest has been paid. If such interest has been paid, either monthly or annually, then the penalty is applied by withholding an equivalent portion of the principal of the bonds.
The penalty is calculated by withholding a percentage of the interest that is directly proportional to the percentage of time, in days, that has not elapsed over the term agreed at the time of purchase. Thus, for example, if the number of days elapsed since the purchase is 22% of the agreed term and 78% of the term remains to be completed, the applicable penalty will be equal to the latter percentage. For the purpose of calculating this penalty, the simple annual interest rate applicable to a bond of the same maturity that would have been issued on the same day, plus 1%, must be used.
In our view, the amount determined under Order Number 10 of the Quebec Minister of Finance does not affect the amount of interest to be reported on the T-5 slip but is an expenditure made to effect a disposition. The redemption of a bond is a disposition for the purposes of the Act. A bond is generally a capital property, i.e., a property whose disposition results in a capital gain or loss. Therefore, the taxpayer will be able in such a case to deduct the amount withheld under Order Number 10 in computing the capital gain or loss arising from the disposition of the bond.
As stated in Information Circular 70-6R5, this opinion is not an advance income tax ruling and is not binding.
Best regards,
Manager
Financial Sector and Exempt Entities Section
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch.