A Surprise for a Cross-Border Investor

I have been practicing US taxes for over forty years. While I believe I am quite knowledgeable in US taxes, I realize there will always be those who know more than I know.  I have been practicing Canadian taxes for a much shorter period of time, so most of my colleagues north of the 49^th parallel know far more than I do.  The unique factor that I bring to the table, however, is how the two systems work together (or don’t work together) so than I can help my clients navigate what can be a “mine field.”  Let me share one “war story” that illustrates the point.

One of my clients is a US Citizen that spends about 5 months each year in the US, but is a Canadian resident. The client’s US investment advisor found some high coupon municipal bonds that offered attractive investment yields. When I found out about the investment, I asked the client to have the investment advisor call me to discuss the investments.  While municipal bonds may be beneficial to the US investor as the interest income is not subject to US income tax, the interest would still be subject to Canadian income tax.  My initial question to the advisor was if this is still a good investment for my client given that the interest is taxable? But there are other issues beyond the taxability by Canada of US municipal bond interest.  To understand the other matters it is necessary to review a couple of the other issues that accompany fixed income investing.

Bonds are usually issued with a “coupon” rate, the term dating from when the investor would clip a coupon from the bond and deposit it with the bank to collect the interest – now most bonds are registered and pay interest by check (cheque for those Canadian readers). A $10,000 bond paying 6% could result in semi-annual interest payments of $300 each.  Bonds are priced, however, using complex formulas that consider, among other factors, the coupon rate and current yields to maturity in the market place.  For example, if current yields in the market were 4%, you would pay more than $10,000 for that 6% Bond.  For ease of illustrating the math involved here, assume that you paid $11,200 for that bond, and it has ten years to maturity.  The $1,200 premium paid on the Bond must be amortized for US tax purposes for municipal bonds, and the taxpayer may elect to amortize the premium for taxable bonds.  That means that each year the interest income is reduced by $120, and the cost basis of the bond is also reduced $120 per year.  When the bond matures, the cost basis will be $10,000 and there will be no gain or loss upon redemption.  Similar rules apply to bonds purchased at a discount, but that is beyond this discussion

Canada does not provide for the amortization of the premium paid on the purchase of bonds – the coupon rate is what is taxable. When the bond is redeemed, there will be a capital loss equal to the premium paid on the purchase of the bond.  In the example above, the 4% municipal interest yield will be tax free the US, but the 6% coupon will be taxable in Canada at regular income tax rates.  Upon redemption, there will be no gain or loss in the US, but a $1,200 capital loss in Canada.  The capital loss will reduce other capital gains, 50% of which is subject to ordinary income tax rates.  If there is a net capital loss, it is not deductible but available for carryover.

So my client got hit with not only with taxable income when he was advised it would be tax free, but also the taxable amount is the full coupon rate rather than investment yield he was anticipating. When the bond matures, he will have a capital loss that may or may not be of benefit.

The lesson—make sure your investment advisor can not only operate in both jurisdictions (this is a securities regulatory matter) but also understands the tax implications in each country.

Contact one of our dedicated professionals to assist in answering your questions and navigating the complexities of international tax compliance.

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