The tax take on fixed income securities

Investing in fixed income securities is often regarded as being relatively complex and, in many cases, limited to investors with at least $50,000 in cash to invest.

I recently learned, when answering a question last week relating to the taxation of fixed income securities, that the taxation treatment of this investment is also extremely complex.

In the answer to my question I had mistakenly thought that fixed income securities were taxed the same as other investments. In other words, if an investor received more than the security cost it was taxed under the capital gains tax rules. This is not the case. In fact, the income of fixed income securities also differs depending on the type of security held.

Qualifying securities

The first type of fixed income investment is called a qualifying security. These include zero coupon bonds, bank bills and commercial paper. In general terms, a qualifying fixed income security has an eligible return of greater than 1.5% and a term of greater than 12 months. These securities have a yield or eligible return in addition to the periodic interest received.

Qualifying securities have the return on the investment calculated under the accrual method of accounting. The yield return of a qualifying security is the difference between its issue price and what the investor is reasonably likely to receive upon maturity.

For example, a two-year corporate bond issued at $92, which is redeemable at $100, has a yield of 8%, or 2% for each six month period. An investor in this corporate bond must calculate the accrual amount for each six-month period and include the accrued return in each of the relevant tax years. For example, if the bond was purchased on January 1, 2014, $2 of return would need to be shown as income in the 2014 return, $4 for the 2015 year, and $2 in the 2016 year.

Where a qualifying security is purchased at a discount after its original issue this could increase the return on the investment that must be calculated under the accrual method. For example, if the corporate bond was purchased in March 2014 for $88 this increases the return for each six-month period from $2 to $3.

Qualifying securities sold before maturity have the same principle applied to calculating how the gain or loss is taxed. If the corporate bond purchased for $92 was sold by the investor in December 2014 for $98, after taking account the $2 declared by the investor on their 2014 tax return, they would include $4 as taxable income on their 2015 tax return. If they sold the bond in December 2014 for $88 they would show an income loss on the 2015 tax return of $6.

The tax treatment of a qualifying fixed income security will apply to an investor that purchases it, even when it has less than 12 months to go until maturity. In other words, when a qualifying security is purchased from an original investor the taxation rules apply to the second investor, even though there is less than 12 months to go until the investment matures.

Traditional securities

The next type of fixed income investment is called a traditional security. This is a fixed income investment that does not have an eligible return of greater than 1.5%, which does not bear deferred interest, and is not capital indexed. This effectively means securities that are issued at a face value, that have the same value upon maturity, are traditional securities. An example of a traditional security is a convertible note.

The interest income received on a traditional security is taxed as ordinary income and any gain or loss realised upon disposal also will be taxed as ordinary income. Where a traditional security is held to maturity and converts to another type of security, such as ordinary shares in the company that issued the traditional security, the gain or loss on the sale of those shares will be taxed under the capital gains tax provisions.

Taxation under TOFA provisions

It would appear that the legislators were not satisfied with the complicated nature of the taxation of fixed income investments with just two types. This can be the only reason why there is a third type of fixed income investment, which are taxed under what is known as the Taxation Of Financial Arrangements provisions.

These provisions were introduced in stages. The first stage was introduced in 2001, with the latest version applying from July 1, 2010. They apply to virtually all investments that are monetary in nature. At first glance the TOFA provisions only apply to very large corporations. This is because they do not apply to individuals. They also don’t apply to certain superannuation funds or managed investments schemes with less than $100 million in value.

Despite this exemption, if an individual or a superannuation fund with less than $100 million invests in a qualifying security that has a maturity term of more than 12 months the TOFA provisions will apply to that qualifying security.

The major effect of any fixed income security caught by the TOFA provisions is not great, as any income earned is assessed as normal income and any losses are deductible. Putting it another way, a fixed income security caught by the TOFA provisions that is a qualifying security does not effectively have the taxation of it changed.

The main difference between a fixed income security caught by TOFA, and those that apply to a qualifying security, is that rather than applying the accrual method for calculating the income or loss for the investment the realisation method can be used in some circumstances. The realisation method applies when the accruals method and the elective tax timing methods do not apply.

If the realisation method applies, gains or losses are included on the income tax return when the gain or loss occurs.

A complex area

If I went on to try and explain what the various elective methods are, and how they may or not apply to you as an investor, I could be accused of inflicting cruel and unusual punishment.

The taxation of fixed income securities are some of the most complex that I have ever encountered. This being the case before completing a tax return relating to fixed income securities you should seek professional advice to make sure you are not making any mistakes.

If the taxation complexities of investing in fixed income securities is too daunting you should consider having your SMSF, which is in pension phase, invest in fixed income securities because no income tax is payable anyway.

Max Newnham is a partner with TaxBiz Australia, a chartered accounting firm specialising in small businesses and SMSFs. Also go to www.smsfsurvivalcentre.com.au.