Bond-washing

3 key takeaways

• Bond washing involves selling a bond just before the interest payment date to avoid paying tax on the interest income.
• The practice exploits differences in tax treatment between interest income and capital gains, often resulting in lower overall tax liability.
• Many jurisdictions have introduced anti-avoidance rules to combat bond washing, as it undermines tax revenue collection.

What is bond washing?

Bond washing is a strategy used by investors to minimize their tax liability by taking advantage of the different tax treatments of interest income and capital gains. The investor sells the bond right before the interest is paid out, thus avoiding the tax on the interest income. They then buy back the bond after the interest payment has been made. The capital gain from the subsequent sale of the bond (if any) is often taxed at a lower rate compared to interest income.

Key Aspects of Bond Washing

• Timing: The strategy hinges on precise timing – selling the bond just before the interest payment date and repurchasing it shortly after.
• Tax Arbitrage: Investors engage in bond washing to exploit the differential tax rates applied to interest income versus capital gains.
• Anti-Avoidance Measures: Governments and tax authorities have implemented rules to close loopholes and prevent bond washing, ensuring fair tax practices.

Real world application

Tax Avoidance Strategy

• Interest Avoidance: By selling the bond before the interest payment, the investor avoids receiving taxable interest income, thereby reducing their immediate tax burden.
• Reinvestment: After the interest payment date, the investor repurchases the bond, effectively maintaining their investment position while having converted interest income into potentially lower-taxed capital gains.

Anti-Avoidance Rules

• Tax Regulations: To counteract bond washing, many tax authorities have implemented regulations that disallow the practice or recharacterize the proceeds from bond washing transactions as taxable interest income.
• Wash Sale Rules: Similar to anti-wash sale rules in equities, these regulations prevent investors from claiming tax benefits if they repurchase the same or substantially identical security within a specified period.

Examples of Anti-Avoidance Measures

• UK: The UK has specific rules under HMRC guidelines that address bond washing, ensuring interest payments are taxed appropriately.
• US: The IRS enforces wash sale rules that prevent investors from deducting losses from securities sold in a wash sale if they repurchase the same or substantially identical securities within 30 days before or after the sale.