Backgrounder: Sales of Linked Notes

A linked note is a debt obligation, most often issued by a financial institution, the return on which is linked in some manner to the performance of one or more reference assets or indexes over the term of the obligation.

A specific income tax rule provides that interest accrued to the date of sale of a debt obligation is included in the income of the vendor for the year in which the sale occurs. However, some investors, who hold their linked notes as capital property, sell them prior to their maturity date to, in effect, convert the return on the notes from ordinary income to capital gains. These investors take the position that no amount in respect of the return on a linked note is accrued interest on the date of sale of the note for the purposes of this specific rule. On that basis, these investors include the full amount of the return on a linked note in the proceeds of disposition and claim the return on the note as a capital gain.

To ensure that any positive return on a linked note retains the same character whether it is earned at maturity or reflected in a secondary market sale, Budget 2016 proposed a deeming rule that would apply for the purposes of the rule relating to accrued interest on sales of debt obligations. This deeming rule would treat all or a portion of any gain realized on the sale of a linked note as interest that accrued on the debt obligation for a period commencing before the time of the sale and ending at that time. When a linked note is denominated in a foreign currency, foreign currency fluctuations would be ignored for the purposes of calculating this gain. An exception was also proposed—in variable C of the formula in proposed subsection 20(14.2)—where a portion of the return on a linked note is based on a fixed rate of interest. Budget 2016 announced that the Sales of Linked Notes measure would apply to sales of linked notes that occur after September 2016.

It is proposed that the measure will only apply to sales of linked notes that occur after 2016. This would provide additional time for purchasers and investment dealers involved in transactions involving linked notes to develop systems to accurately capture and report relevant information under the measure. 

It is also proposed that variable C of the formula in proposed subsection 20(14.2) be removed from the deeming rule. This proposed change would simplify the calculation of the deemed interest amount and the associated reporting requirements under the measure.