Taxes on Canadian Government Strip Bonds

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bigricardo
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Taxes on Canadian Government Strip Bonds

Post by bigricardo » Thu Mar 10, 2005 2:16 am

Hi, I have a Government of Canada strip bond expiring in 2008. I bought it last year. Do you have to report anything on my US tax return this year?

nelsona
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Post by nelsona » Thu Mar 10, 2005 6:28 am

The IRS (unlike CRA) allows taxpayers to reprot interest on a 'cash basis', meaning that you only report and pay tax on interest as you actually recieve it.

So, if you choose this method, you don't report any interest income until you actually get it.

Canada, doesn't allow this method, and thus (if you were in Canada) you would be reporting and paying tax on this interst every year: the accrual method.

Since you are non-resident, Canada cannot (by treaty) tax its gov't bond interest, so this gives rise to a neat tax-free situation, should you return to Canada before 2008 (as a non-US citizen).

In US, if you chose the cash method, you wont pay tax on interst earned in 2004, 2005, 2006, 2007.

In canada, if you return say in 2008, you will only pay Cdn tax on the interest portion for 2008, not the entire interest cash-out.

<i>nelsona non grata</i>

bigricardo
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Post by bigricardo » Thu Mar 10, 2005 2:12 pm

I didn't know about this. So, even though the *value* of the strip bond increases each year (as shown on my regular statements), I don't have to pay any tax on this increase until the bond is cashed out (ie. I don't have to pay capital gains)?

nelsona
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Post by nelsona » Thu Mar 10, 2005 2:47 pm

the increase of value in a bond (that you aren't selling) is defined as interest in both Canada and US.

When you bought a $1000 bond at $900, and you hold it until it matures, the $100 is interest. Canada insists that this interst be reported annually. US does not.

If you had other Cdn bonds (non-Govt), the interest would have NR tax deducted every year. But Govt bonds are tax exempt for non-residents by treaty.

It is when you sell it before maturity, that you would trigger a cap gain (or loss).

<i>nelsona non grata</i>

worryfreeinvestor
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Post by worryfreeinvestor » Mon Apr 25, 2005 2:34 pm

I am a Canadian resident who will become a US resident in May 2005. In 1994, I bought a Canada stripped coupon that matures in 2013. Of course, it is in my RRSP, so I have paid no Canadian income tax on the accruing annual interest. After I've moved to the US, I plan to defer the taxes on the interest income as per Rev Proc 2002-23.

I understand that I can account for the interest to the IRS by either accrual or cash methods. It seems to me that I should use the accrual method, because this means that I can start reporting the interest income from 2005, whereas if I use the actual cash method, I will have to report, in 2013, all the interest earned since 1994. That is, if I use accrual, the IRS will not care what happened to the accrued interest earned before I became a US resident, and I will be able to walk away with the interest from 1994 through 2004 tax free. (I do not plan to ever become a resident of Canada again.) Have I appreciated these two options correctly?

On the other hand, I will be a resident of California, which does not allow me to defer taxes on phantom income from assets held inside my Canadian RRSP. So, will I have to pay taxes on the accrued income to California because I report annual accruals to the IRS, or can I report on a cash basis to California? I suppose that if it's possible to do the latter, California will tax me in 2013 on all the income from 1994, so I will not dodge ten years' worth of income tax to California. There is no free lunch!

Any advice/clarification greatly appreciated.

nelsona
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Post by nelsona » Mon Apr 25, 2005 6:00 pm

Since you will be electing to defer taxation on your yearly income, it doesn't matter how you report the yearly income for federal tax , becuase you won't be reporting the income.

When you withdraw funds from your RRSP, you will pay tax based on the book value you establish when you become US tax resident (which will either be May of 2005, or earlier jan 2005, if you elect to file full-year US resident). It won't matter whether you get the interest this year, next year, or or 2013.

Your analysis of the Cali situation seems bang-on.

if this bond was being held outside an RRSP, it would not be taxable in Canada at all, so you are gaining nothing now that it is in your RRSP.

<i>nelsona non grata... and non pro</i>

worryfreeinvestor
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Post by worryfreeinvestor » Mon Apr 25, 2005 11:55 pm

Nelsona, thanks for the advice. I now understand the US situation quite well, but you've confused me on the Canadian one! In your first reply in this thread, you pointed out that CRA taxes Canadian residents via annual accrual on strips. That's why Canadian residents don't tend to own them in unsheltered accounts. Now you say that CRA does not tax. Are you now referring to the situation for a non-resident of Canada, to whom CRA applies zero withholding tax? Remember I bought this thing in 1994, long before I had the notion to move to the US. Therefore, I see no reason to swap it out of my RRSP, or do I?

nelsona
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Post by nelsona » Tue Apr 26, 2005 5:52 am

Yes, I am refering to your non-res status, since US residents do not pay tax on Cdn gov't bonds by treaty

You can do the analysis yourself, but if you leave the bond in your RRSP at some point you will pay tax in Canada on that interest (at either 15% or 25%). If you swap it out, you will not pay any Cdn tax on the interest (nor on any cap gain if you sell it early).

This may not save you any tax overall, as your fed marginal rate may be 25% in US. So you'd merely be paying more in US

<i>nelsona non grata... and non pro</i>

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