DEBT INSTRUMENTS WITHOUT ANNUAL INTEREST PAYMENTS
Most debt instruments, such as corporate and government bonds and GICs, pay interest at least annually. As such, you normally just report your interest in income in the year in which you receive it or it is receivable by you.
However, some debt instruments do not carry an annual rate of interest, and some are issued at a discount to their face amount. Examples of these instruments include government treasury bills and zero-coupon bonds. Other debt instruments, like certain term deposits, are issued at face value but all of the interest is payable upon maturity rather than annually. For these instruments, a special interest accrual applies.
Basically, the special accrual rule means that you cannot defer reporting all the interest until it is paid to you – and in this case of a long-term zero coupon bond, this could be 10 or 20 years or more. Instead, you are required to report the interest on an accrual basis. More particularly, you must include in income, for a taxation year, the interest that accrues to an “anniversary day” in the year. The anniversary day is one year less a day from the day the instrument is issued, plus every subsequent annual anniversary day until the instrument matures.
Note that since the first anniversary day will occur in the calendar year following the year the instrument is issued, you can effectively defer reporting interest that accrues to December 31 of that first year.
You purchase a 3-year term deposit on July 1, year 1. It matures on June 30, year 4. All of the interest is payable on June 30, year 4.
The first anniversary day will be June 30, year 2. As such, twelve months’ worth of interest, from July 1, year 1 to June 30, year 2, will be included in year 2. This means that the interest that accrued throughout the second half of year 1 is not taxed in year 1 but rather year 2.
A similar rule applies to a corporation owning this type of debt instrument, except there is no anniversary day rule. A corporation must simply include in income all the interest accrued to its taxation year-end. Thus, if your corporation has a calendar-year taxation year and it purchases the term deposit in the above example, it will include in year 1 the interest accrued to December 31, year 1. In year 2 it will include the interest accrued to December 31, year 2, and so on.