Madhusudan Kabra

An Analysis on Tax Free Bonds V/S Tax Saving Bonds

At Present in Indian Market, Various Financial Institutes and Other Authorities are issuing various types of bonds such as Tax Free Bonds, Tax Saving Bonds.  The Major Players in Tax Free Bonds are NHAI, Power Finance Corporation (PFC), Indian Railway Finance Corporation (IRFC) whereas in Tax Saving Bonds – L&T and IDFC are major players.

The basic difference between Tax Free Bonds and Tax Saving Bonds is:

  • Tax free Bonds yields Interest which is not taxable in the hands of Investor whereas in case of Tax Saving bonds it is chargeable to Tax in hands of Investor.
  • Investor gets Deduction under Section 80CCF if he invests in Infrastructure Tax Saving Bonds up to Rs. 20,000 whereas same is not available in case of Tax free Bonds.

About Tax Free Bonds:

Recently National highway Authority of India (NHAI) has launched Tax free Infrastructure bond. The said bond is listed in NSE and BSE having “AAA” rating which represents highest safety and stability. It is for the very first time where NHAI has been allowed to raise Rs. 10,000 Cr. Through Tax free bond with a coupon rate of  8.2 % for 10 year and 8.3 % for 15 years which will be majorly used in acquiring land for various projects. It is needless to mention here that NHAI is allowed to raise fund through 3 Years 54EC bonds. The said bond has no minimum Lock-In-Period and investor can use exit routes by selling off the bonds on Stock Exchanges. Power Finance company (PFC) also opened its issue on 30th December, 2011. It is offering rates similar to NHAI. PFC’s offer for bonds is last on 16th January, 2012.

About Tax Saving Bonds:

Tax Saving Bonds – are instruments used for Individual Income Tax savings. They have not been as popular as some of the other Tax saving instruments, but are ideal for people who have low risk appetite and are looking to preserve their income in the longer run and also accrue benefit of tax savings. In Union Budget 2010-2011, a new section 80CCF was inserted under the Income Tax Act, 1961 – to provide for income tax deductions for subscription to long-term infrastructure bonds. These long term infrastructure bonds offer an additional window of tax deduction of investments up to 20,000. Recently L&T and IDFC have come up with an Issue for Tax-saving bonds.  There is Minimum Lock-In-period for 5 years in Tax Saving Bonds. Investor can sell it on stock exchanges post Lock-In/ buy back offers. The interest rates are 9% . L&T infrastructure bond assigned to credit rating as “AA+”, However IDFC infrastructure bonds have got the highest credit rating of “AAA”.

This article discusses the comparability and expected yields from tax free bonds, tax saving bonds and Bank Fixed Deposit.

On the face of it, these 8.2-8.3 % Tax-free bond issued by NHAI, PFC are very much comparable to other investments which yield 12% pre tax return. These bonds are even better than Bank fixed deposits, which are currently giving about 9% (pretax) returns. The aforesaid bonds are even better from Tax saving Infrastructure Bonds issued by L&T, IDFC, if we consider effective rate of return on the Bonds.

The example given below demonstrates the same.

Assuming we are Investing Rs. 1,00,000 in each Three i.e. Tax Free Bonds, Tax Saving Bonds and Bank Fixed Deposit.  Let us assume that the said Investment is over and above Investment made under section 80C.

Let us compare the Return from each three investments one by one

√  Case I   :   Comparison of Tax Free Bonds with Bank FD

√  Case II   :  Comparison of Tax Saving Bonds with Bank FD

√  Case III  :  Comparison of Tax Free Bonds with Tax Saving  Bonds.

Case I:       Comparison of Tax Free Bonds with Bank F.D.

Analysis of Rate of Return

Tax Free Bond

Bank FD

Investment

Rs. 100000

Rs.100000

Tax Saving
(Assuming 30% tax slab) (A)

                           –

                           –

Interest Rate

8.20%

9.00%

Post tax Interest Rate

8.20%

6.22%

(Tax Free)

(Taxable)

Interest Earning  (B)

8200

6219

Total Earning (A+B)

8200

6219

Effective Rate of Return

                      8.20

6.22

 Conclusion : Here Investment in Tax free bonds will yield ROR of 8.20% as compare to Bank fixed deposit which yield ROR @ 6.22%. Hence we can conclude that it is better to go for Tax Free bond because it gives us return of Rs. 8200/- as compare to Bank fixed deposit return which is only Rs.6220/- . Alternatively, We can say Tax Free bonds are yielding 132% return as compare to Bank fixed deposit. Here if we consider the span of 5 years, the aggregate return will be 41% (8.20 % *5 years) in case of Tax Free Bonds and 31.1% (6.22*5 years) in case of bank FD. As the return in hands of investor remain same, thus we can conclude that time horizon will not make any difference in earnings of the investor in the above case.

 Case II:     Comparison of Tax Saving Bonds with Bank FD

Analysis of Rate of Return

Tax Saving Bond

Bank FD

Investment

Rs.100000

Rs. 100000

Tax Saving U/s 80CCF
(Assuming 30% tax slab) (A)

6180*

0

Interest Rate

9%

9.00%

Post tax Interest Rate

6.22%

6.22%

(Taxable)

(Taxable)

Interest Earning  (B)

6219

6219

Total Earning (A+B)

12399

6219

Effective Rate of Return

12.40

6.22

 (*Tax Saving: Rs 20,000 x 30.9 % Tax Maximum amount available as deduction is Rs. 20000 under section 80CCF.  Hence the maximum tax benefit that can be availed is Rs 6180/-.)

√ Conclusion: If we consider Investment at a span of One year the Tax Saving Bonds yields ROR @ 12.40% whereas yielding ROR for Bank fixed deposits is @6.22%. Hence we can conclude that it is better to go for Tax Saving Bonds because it gives us effectively Rs. 12400/- as compare to Rs 6220/- earned from Bank Fixed Deposits. Alternatively, We can conclude that Tax Saving Bond is yielding 199% return as compare to Bank Fixed Deposits.

√  Again if we consider period of 5 years the earning ROR of investor would be as follows in both the cases:

Aggregate Effective Rate of Return for five years

Investment Option 

Year

Tax Saving Bond

Bank FD

First year

                         12.40

                    6.22

Second Year

                           6.22**

                    6.22

Third Year

                           6.22

                    6.22

Fourth Year

                           6.22

                    6.22

Fifth Year

                           6.22

                    6.22

Aggregate Effective ROR for Five years

                         37.28

                 31.10

 **No deduction u/s 80CCF for 2nd & subsequent years.

It is clear from above table that even from 2nd year onwards ROR of both the option are same but the aggregate effective ROR for five years is higher in case of Tax saving Bonds as compared to Bank fixed deposit. This is because in the first year investor can claim deduction up to Rs. 20,000 which is not available in case investment made in Bank fixed deposit.

Case III:  Comparison of Tax Free Bonds with Tax Saving Bonds.

Calculation of Effective Rate of Return

Tax Free Bond

Tax Saving Bond

Investment

Rs.100000

Rs. 100000

Tax Saving U/s 80CCF
(Assuming 30% tax slab) (A)

                           –

6180*

Interest Rate

8.20%

9%

Post tax Interest Rate

8.20%

6.22%

(Tax Free)

(Taxable)

Interest Earning  (B)

8200

6219

Total Earning (A+B)

8200

12399

Effective Rate of Return

                      8.20

12.40

(*Tax Saving: Rs 20,000 x 30.9 % Tax Maximum amount available as deduction is Rs. 20000 under section 80CCF.  Hence the maximum tax benefit that can be availed is Rs 6180/-.)

Conclusion: At a span of one year Tax Free Bonds yields ROR@8.20% whereas investment in Tax Saving Bonds yields ROR @ 12.40%. Hence we can say it is better to go for Tax Saving Bond because it yields effectively Return of Rs. 12400/- as compared to earnings of Tax Free Bonds which is Just. Rs. 8200/-.  However if period of five year is taken into consideration the scenario would be as follows:

Aggregate Effective Rate of Return for five years

Year

Tax Free Bond

Tax Saving Bond

First year

8.20

12.40

Second Year

8.20

6.22**

Third Year

8.20

6.22

Fourth Year

8.20

6.22

Fifth Year

8.20

6.22

Aggregate Effective ROR for Five years

41.00

37.28

** No deduction u/s 80CCF for 2nd & subsequent years.

It is clear from above table that at a span of five years the overall return in the hands of the investor is higher in case of Tax Free Bonds as compared to Tax Saving Bonds and Bank Fixed Deposits. This is actually nothing but just an opposite of what conclusion we have drawn from one year calculation.

Thus we can conclude that Tax saving bonds may yield quite higher return than Bank FD and Tax free bond in the initial year but at the span of 5 years Tax Free Bonds yields higher rate of return.

However if we just consider Post tax rate of Interest, Tax free Bonds are best among other alternatives as the Interest earning of Tax Free Bonds are not chargeable to tax.

By  Madhusudan Kabra, CRO-0252857,     Student-CA Final

 

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0 responses to “Tax Free Bonds V/S Tax Saving Bonds”

  1. Madhavan says:

    Hi Team,

    Very good article at least it cleared my basic doubt on to the tax applicability on Income of investment over Investment

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