April 23, 1993
| Audit Technical Support | Financial Industries Division |
| Division | Michael Cooke 957-8953 |
Attn: E. A. Shultis
Valuation Services Section
Zero Coupon Bonds
We are writing in response to your memorandum of April 15, 1993. You have asked for our opinion concerning the proper income tax treatment of the interest and capital components of zero coupon bonds.
For taxation years commencing after 1981, zero coupon bonds are debt instruments described in paragraph 7000(1)(a) of the Income Tax Act Regulations (the "Regulations"). Accordingly, interest income is deemed to accrue on such instruments as prescribed in paragraph 7000(2)(a) of the Regulations, which requires the determination of a yield rate using assumptions concerning the interest rate and compounding period that will result in a present value, at the time of acquisition, of the maturity value (as stated in CDN$ using the exchange rate in effect at the date of purchase) equal to the cost (in CDN$) to the taxpayer, applicable for all periods up to the time of disposition. We enclose a copy of a sample interest calculation taken from the 1982 Explanatory Notes for Regulation 7000(2)(a).
Where an amount of interest is determined on the debt instrument, as discussed above, it would be included in the taxpayer's income under subsection 12(3) of the Act, or upon disposition by the taxpayer pursuant to subsection 20(14) of the Act and would be added to the cost base of the debt pursuant to subsection 52(1) of the Act. The difference between the proceeds of disposition (as stated in CDN$ using the exchange rate in effect at the date of sale) and the cost base, if any, will be the capital gain or loss, including any foreign exchange gain or loss as computed under subsection 39(2) of the Act. Where these instruments are traded for speculative purposes however, any gain or loss would be on income account.
It appears however, that since one of the taxation years involved commenced before 1981, assuming an October 31 year end, Regulation 7000 does not apply in respect of that year. While Interpretation Bulletin IT-114 sets out some general guidelines on the treatment of discounts its planned update has been put on hold pending the outcome of the Department of Finance's review of interest. In any event we suspect that taxation year is statute barred.
We trust that the above will be of some assistance, however if you require additional assistance with respect to your particular case, please contact the writer.
for DirectorFinancial Industries DivisionRulings DirectorateLegislative and Intergovernmental Affairs Branch