Principal Issues: What exchange rate should be used for accrued interest under subsection 12(9) on a stripped interest coupon.
Position: For the purposes of calculating deemed interest on a stripped coupon under subsection 12(9) and paragraph 7000(2)(b) of the Regulations, the accrued interest from a stripped coupon that must be included in a taxpayer’s income is the amount accrued during the days indicated in paragraphs 12(3) or 12(4). When a stripped coupon is denominated in foreign currency, the interest deemed to have accrued on the stripped coupon during that period is determined in that foreign currency under paragraph 7000(2)(b) of the Regulations, and the exchange rate to be used for the conversion of that currency is the relevant spot rate for each of the days during which the deemed interest accrued.
Reasons: The timing of the inclusion of the interest income is specified under subsections 12(3) and 12(4).
FINANCIAL STRATEGIES AND FINANCIAL INSTRUMENTS ROUNDTABLE, 3 NOVEMBER 2023
2023 APFF CONFERENCE
10. Exchange rates and imputed interest
The Income Tax Act provides for the inclusion of imputed interest for certain financial products. For example, this is the case for prescribed debt obligations, such as stripped coupons, pursuant to subsection 12(9) I.T.A..
Subsection 261(2) provides that a taxpayer is required to report its Canadian tax results in Canadian dollars and, on page 12 of the Federal Income Tax and Benefit Guide (footnote 1), it is stated that "[i]n certain circumstances described in Income Tax Folio S5-F4-C1, Income Tax Reporting Currency, an average rate may be used to convert foreign currency amounts”.
Question to CRA
Where a security, such as a stripped coupon on which the Income Tax Act deems interest to accrue, is denominated in a foreign currency, what date should be used to apply the exchange rate?
CRA Response
This answer assumes that the taxpayer holding the stripped coupon is not a financial institution.
Where a taxpayer acquires an interest in, or a right to, a debt obligation to which the Income Tax Regulations apply, an amount calculated in the prescribed manner is deemed to have accrued as interest on that debt obligation in each taxation year in which the taxpayer holds the interest or right. Thus, subsection 12(9) subjects accrued interest on prescribed debt obligations to tax in order to ensure that income attributable to the return on the obligation is taxed as interest. Subsection 12(9) will generally take into account the cost of a stripped coupon and will therefore generally not tax the taxpayer on the full amount of the stripped coupon.
Subsection 7000(1) I.T.R. provides the definition of "prescribed debt obligation" for the purposes of subsection 12(9) and subsection 7000(2) I.T.R. provides the formula for determining the amount that is deemed to accrue on a debt obligation as interest to a taxpayer in each taxation year in which the taxpayer holds an interest in a prescribed debt obligation. Pursuant to paragraph 7000(1)(b) I.T.R., a "prescribed debt obligation" includes a debt obligation in respect of which the proportion of the payments of principal to which the taxpayer is entitled is not equal to the proportion of the payments of interest to which the taxpayer is entitled. A stripped coupon is generally a "prescribed debt obligation" pursuant to paragraph 7000(1)(b) I.T.R..
Pursuant to subsection 12(9.1), where a taxpayer disposes of a stripped coupon, the portion of the proceeds of disposition received that can reasonably be considered to be a recapture of the cost of the interest or right on the debt obligation is not included in computing the taxpayer's income (footnote 2).
Paragraph 261(2)(a) I.T.A. provides that a taxpayer should generally convert any amount that is required to be taken into account in computing the taxpayer's "Canadian tax results" into Canadian dollars "using the relevant spot rate for the day on which the particular amount arose.”
The term "relevant spot rate", defined in subsection 261(1), will generally be the rate quoted by the Bank of Canada on the particular day (or the closest preceding day if not quoted on the particular day).
The definition of "Canadian tax results" in subsection 261(1) includes, among other things, any amount that is relevant in determining income, taxable income, or taxable income earned in Canada and the amount of tax payable or refundable. Any amount included in the calculation of deemed accrued interest under subsection 12(9) is therefore relevant in determining Canadian tax results (the taxpayer's income in this case) and must be converted into Canadian dollars on the day it arose.
It should be noted that the amount of deemed accrued interest under subsection 12(9) that will be included in income varies, by virtue of subsection 12(3) or 12(4), depending on the type of taxpayer. Subsection 12(3) applies to a corporation, partnership, unit trust or any trust of which a corporation or partnership is a beneficiary. Subsection 12(4) applies to taxpayers to whom subsection 12(3) does not apply.
For the purposes of determining, pursuant to paragraph 261(2)(a), the relevant spot rate in determining the income of a taxpayer holding a stripped coupon to which subsection 12(3) applies, the day on which the amount of interest deemed to accrue under subsection 12(9) arises is generally each day of the taxation year in which the accrued interest arises. This period ends at the end of the taxpayer's taxation year or on the day the interest is received if the interest is received before the end of the taxation year.
For a taxpayer holding a stripped coupon to which subsection 12(4) applies, the day on which the amount corresponding to the accrued interest arises will generally be each day of the taxation year during which the accrued interest is generated. This period extends to the "anniversary day", as defined in subsection 12(11) (the anniversary day includes the day on which the contract was disposed of).
The accrued interest to be included in a taxpayer's income in respect of a stripped coupon is that generated during the days indicated in subsections 12(3) and 12(4). Consequently, where the stripped coupon is denominated in a foreign currency, the interest deemed to have accrued during that period on that stripped coupon is determined in foreign currency, pursuant to subsection 7000(2) I.T.R., and the exchange rate applicable to the conversion of that currency into Canadian dollars for the portion accrued during each of those days must be used.
Furthermore, for the purposes of calculating capital gains or losses on a security such as a stripped coupon, the cost of each security must be converted into Canadian dollars using the relevant spot rate on the day of acquisition and the proceeds of disposition must be converted using the relevant spot rate on the day of disposition of the stripped coupon pursuant to subsection 261(2).
John Fowler
November 3, 2023
2023-097865
FOOTNOTES
Note to reader: Because of our system requirements, the footnotes contained in the original document are shown below instead:
1 CANADA REVENUE AGENCY, 5000-G Federal Income Tax and Benefit Guide.
2 See also CANADA REVENUE AGENCY, Technical Interpretation 9103705, June 13, 1991.