Reporting Interest Income

It really is time to do that income tax return, with the April 30 deadline for individual filers fast approaching. And reporting interest income deserves particular attention this year, if you are among the worried investors who exchanged stocks for the “safe” havens of interest-bearing debt obligations such as guaranteed investment certificates (GICs) and Canada Savings Bonds.

Indeed, the guaranteed return of principal and income resulting from the government using your money is attractive. But it is not all it appears to be: these interest-bearing investments are neither tax-efficient nor inflation-proof. If you take taxes and inflation into account, over time, you will actually lose both principal and purchasing power.

Consider the tax filing rules. Interest reporting follows two basic tax rules:

• You must report the interest in the taxation year in which it is received or receivable.

• Compounding allows you to earn interest on interest during the term of the contract. On your income tax return, you must report all interest income that accrues in the year ending on the debt’s anniversary date. So, you pay taxes on income you haven’t received as you’ve effectively reinvested the pre-tax interest at the same rate as the principal pays.

The issue date of the debt instrument is important because reporting stems from that date rather than the date of ownership. For example, because of the annual reporting rules, which apply to investments acquired after 1989, an issue date of Nov. 1, 2011, does not require interest reporting until the following year, that is 2012. In other words, the accrual of interest for the two-month period of Nov. 1 to Dec. 31 is not reported in the 2011 tax year.

Things get even more tricky when investment contracts have unique features, such as:

• they do not bear interest and are sold at a discount to their maturity value;

• the interest rate of the instrument is adjusted for inflation over time;

• the rate of interest may increase as the term progresses;

• interest payments may vary with the debtor’s cash flows or profits;

• if the instrument is transferred before the end of the term, a reconciliation of interest earnings must take place.

It’s Your Money.  Your Life.  Interest received or accrued each year must be reported as investment income on Schedule 4 – Statement of Investment Income and Line 121 of the tax return.  Remember: you must report interest income earned even if you did not receive a T slip.  Get help from your tax advisor in the trickier situations.

Next time — Evaluating CSB returns: Taking inflation into account

Evelyn Jacks is president of Knowledge Bureau and author of Essential Tax Facts 2012 and co-author of Financial Recovery in a Fragile World.  Follow her on twitter @evelynjacks

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