The taxation of fixed interest securities is complex. Superannuation expert, Tony Negline looks at tax on bonds including foreign currency bonds
The taxation of fixed interest securities is very complex. In fact it is so complex that I encourage any investor using these products to seek professional assistance to make sure they have not made an error in their calculations.
Income is subject to income tax rules
This is a standard rule. You earn income, the government wants to tax it. This includes most capital gains from investments.
Individuals will pay tax at their marginal rates. Smaller companies – carrying on a business and turnover of less than $25 million – will pay 27.5%. All other companies pay 30% tax.
Super funds pay 15% for assets in the accumulation phase and 0% for pension assets. Higher net wealth investors who have had to move assets out of pensions because of the 2016 super reforms will now have assets in their super funds taxed at 15% and 0%.
There is a CGT uplift concession that may be available. It is only available on investments which are subject to CGT.
How have you invested into a fixed interest security?
If you invested via a managed fund then the operators of that fund will handle all tax aspects and then pass your share of those aspects to you so you can add them into the income tax return of entity that owns that investment. If you sell or redeem any units then the capital gains tax rules will need to be considered.
If you invested directly into fixed interest securities then all the rules mentioned below are relevant.
Term deposits
Any interest you earn is taxable if your tax rate is greater than 0%. Your invested capital is returned to you tax-free.
Qualifying securities
This is a security with a rate of return greater than 1.5% with a term to maturity of more than 12 months.
It often includes zero coupon bonds, bank bills and commercial bonds which yield returns as well as interest payments.
Income subject to tax is determined on an accrual basis which can be quite tricky to work out.
You can ask the issuer if you have a qualifying security.
If you sell a qualifying security then the difference between the sale proceeds and the accrued amounts is either income for tax purposes or allowed as a tax deduction.
Taxation of Financial Arrangements (TOFA)
This will apply to individual investors and super funds with less than $100 million that invest in a qualifying security with a term to maturity of more than 12 months.
Under TOFA all gains are taxed as income and all losses are allowable deductions unless there are specific exemptions.
If an arrangement does not cease during a year then an investor can apply different tax timing rules. Some of these apply automatically while others you need to elect to use them.
And finally there may be a TOFA balancing adjustment.
Traditional Securities
The following tax rules will apply to most securities that do not satisfy the qualifying security rule mentioned above unless you’re deemed to be in the business of trading securities or it’s a prescribed security.
Typically a traditional security will be one issued at face value and has the same value on maturity.
The return of the security is the difference between the likely payments (other than periodic interest) and its issue price at the time of first issue.
Interest payments are subject to tax and any gain on disposal – in simple terms, proceeds less cost of acquiring asset – will also be subject to tax.
Losses are allowed as a tax deduction.
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However be careful because in some cases the capital gains tax provisions might apply. For example, if the bond converts to shares then the sale of those shares will be taxed under the CGT rules.
Some large investors will have their traditional securities taxed under TOFA.
Investments in a currency other than AUD
Where the securities are denominated in foreign currency, where relevant, consideration needs to be given to any double tax agreement that Australia has with the country in which the securities were issued.
In an Australian context there may be tax implications upon the “realisation” of the foreign exchange gain or loss.
Specific tax rules may apply to determine when a foreign exchange realisation occurs. Upon realisation, a gain or loss from the foreign currency arrangement is brought to account for income tax purposes. If the gain or loss is in relation to either cash, a qualifying security, a traditional security or a financial arrangement dealt with under TOFA, the gain will generally be assessable and the loss deductible. CGT provisions would generally not apply because of the anti-overlap provisions.
Conclusion
The tax rules applying to fixed interest securities are complex and as I said in the introduction I would encourage you to take professional advice.