Markets Explained

Income, Capital Gains and Taxation

Tab 1 of 3


Fixed-rate capital securities pay monthly, quarterly or semiannual distributions that, like interest payments on bonds, are fully taxable to the investor. Investors should be aware that, unlike other bonds, most fixed-rate capital securities include a provision allowing the issuer to defer distributions for up to five years. Although deferral would be permissible only if the issuer also suspended all dividends on its common and preferred stock (like regular preferred stock), investors in fixed-rate capital securities could have their income interrupted if this situation were to occur. During such a period, the investor would incur a tax liability on the deferred income, which continues to accrue, typically at a compounded rate, even though it is not actually paid. Investors can avoid such a tax obligation by holding their securities in a tax-deferred retirement account. At the end of the deferral period, the issuer would be required to pay all deferred distributions.

Tab 2 of 3

Taxability of Income

The treatment of investment income from trust and debt securities for federal income tax purposes is unclear under current tax statutes and regulations and may vary depending upon whether the possibility of the issuer deferring payments is, or is not, a remote contingency. If deferral is a remote contingency, payments should be included in income by a holder as such payments are accrued or received, depending upon the holder’s method of accounting. If deferral is not a remote contingency, the income may be treated as original-issue discount (OID) and both cash and accrual investors would be required to report accrued OID even if it is different than the amount received. In general, for investment-grade issuers who pay common stock dividends, payments will be treated as interest, not OID. Ask to check the prospectus for applicability.

A holder who purchases such fixed-rate capital securities in the secondary market for a price in excess of the original-issue price plus accrued OID (including income treated as OID) may reduce income accruals by the amount of such excess by including income on a constant yield-to-maturity basis. Consult your tax adviser for specifics.

Should the issuer elect to defer payments, the deferred income continues to accrue for tax purposes, even though the investor receives no cash payments with respect to the security. To avoid the impact of a tax liability on “phantom” income that accrues but is not actually received, investors may wish to hold these securities in qualified tax-deferred retirement accounts.

Income from partnership securities is generally reported to investors on a simplified K-1 form. In general, partnership issuers use a monthly convention that allocates the income accrued on the underlying debentures of the parent to the persons holding the partnership securities at the end of each month. Accordingly, although partnership investors, like investors in trust and debt securities, are required to accrue such income even during a deferral period, the income only has to be accrued by the partnership holders at the end of each month rather than on a daily basis. For investors who purchase the securities at original issuance, this distinction will only affect the investor who sells a security prior to the end of the month. With respect to a trust or debt security, such investor would be taxed on accrued income to the date of sale. However, with respect to the sale of a partnership security, such investor would only pay tax at ordinary income tax rates on income accrued through the prior month end; the portion of the sale price attributable to income accrued during the current month through the date of sale would instead be taken into account in computing a capital gain or loss.

Investors are advised to consult their tax adviser prior to investing to make sure they completely understand the tax implications of the security they are considering.

Tab 3 of 3

Calculating Capital Gains or Losses

As with bonds and preferred stock, if fixed-rate capital securities are sold or otherwise disposed of prior to maturity, the investor may realize a capital gain or loss on the transaction. The amount of gain or loss will equal the difference between the amount realized from the sale and the adjusted tax basis, which includes the amount of accrued but unpaid income required to be included by the seller through the date of sale.
For example:4

Purchase price: $25.00
Sale proceeds: $26.10 [including $0.40 in accrued income]
Adjusted tax basis: ($25.40) [purchase price + $0.40 accrued income in sale price]
Capital gain: $0.70

In the case of a partnership security purchased at original issuance, generally no accrued income will be included in the seller’s adjusted tax basis unless the issuer has deferred income payments.

Where the seller had purchased a security of any type in the secondary market, any portion of its purchase price attributable to income accrued prior to its purchase will be included in basis.

Although a gain or loss on a sale of a security is generally considered to be capital, special rules apply to shares of securities purchased at “market discount,” i.e., for an amount less than the original-issue price plus accrued original-issue discount. In such a case, a portion of any gain up to the amount of accrued market discount is taxed as ordinary income, unless the seller had elected to include accrued market discount in income on a current basis.

The tax calculations on fixed-rate capital securities can be quite complex. To reiterate, investors should consult their own tax advisor prior to investing to make sure they understand the tax implications of the securities they are considering.

4 This is a simplified example included for illustrative purposes only.