Taxation of bonds and debentures

Any profit made on sale of an investment generally referred to as capital asset under the income tax laws becomes taxable as short term or long term capital gains depending on the holding period of such asset. Different holding periods, ranging from 12 months to 36 months, are prescribed for different class of assets to qualify as long term capital asset.  Long term capital gains qualify for concessional rate of tax as well as are eligible for exemption if investments are made.  The qualifying holding period for debentures and bonds also varies depending on whether the same are listed or not. Let us discuss the tax provisions on  taxation of incomes which arise periodically as well as on redemption or sale of bonds and debentures (both referred to as bonds hereinafter for brevity). 

Taxation of interest

Bonds generally are entitled to receive interest at periodic interval or in case of cumulative bonds the interest is payable at the time of maturity of the instrument. The interest on bonds is taxable under the head “Income from other Sources” and is taxed at the slab rate applicable to you. The interest income on the bonds can be offered for tax either on receipt basis or on accrual basis. The method for taxation of such income once adopted has to be followed consistently. In case of cumulative bonds, it is advisable to offer the interest on accrual basis to avoid exceptionally high liability on receipt of large income at the time of maturity. It may be noted that the difference between the issue price and the face value of the zero coupon bonds becomes taxable as capital gains as no coupon rate is specified on such bonds. In case of tax free bonds thought interest on such bonds is tax free but any appreciation realised at the time of sale or redemption is taxed as short term capital gains or long term capital gains depending on holding period and whether these are listed or not.

Short term or long term

The taxation of any profits made either at the time of sale or redemption of bonds will vary depending on the period for which such bonds have been held by you. Generally any profit on sale/redemption will become taxable as long-term if the same have been held for more than 36 months on the date of such sale/redemption. Thus profits made on sale of bonds shall be taxed as short term in case they have been held for 36 months or less. However in case the bonds which are listed on any stock exchange in India, the qualifying period is 12 months in stead of 36 months for it being treated as long term. So in case of listed bonds the holding period requirement is more than 12 months. So for bonds which are not listed one has to wait for 36 months to avail the benefits associated with long term capital asset.

Tax rates on short term profits and long term profits

For any short term capital gains, based on the holding period discussed above, made on bonds either at the time of sale or redemption are taxed at the slab rate applicable to your income which varies between 5% to 30% and surcharge and cess as applicable. However in case of long term capital gains on bonds, the same are taxed at the flat rate of 20% (cess and surcharge extra) irrespective of quantum of amount of such long term capital gains.

There is difference in the method for computation of short term can long term capital gains. The short term capital gains are computed simply by reducing the cost of acquisition of such bonds from the sale/redemption price. However for long term capital gains, you are entitled to enhance your cost of acquisition by a cost inflation index notified by the government with reference to your year of acquisition and sale/redemption. The benefit of inflating your cost of acquisition is available only in respect of Capital Indexed Bonds issued by the government and Sovereign  Gold Bonds issued by the Reserve Bank of India. Likewise for a non resident any appreciation in the redemption value of the  rupee denominated bonds of an Indian Company due to fluctuation in  Indian currency against the foreign currency is not taxed. In case of bonds which are listed, the taxpayer has the option to pay tax at 10% of the profits on sale or redemption. However the option to pay tax at concessional rate of 10% in stead of 20% is not available for zero coupon bonds.

Tax exemptions available in respect of long term capital gains arising on bonds

The tax payer has an option to avail exemption on the long term capital gains tax under Section 54 F by investing the net sale proceeds in buying a residential house subject to fulfilment of certain conditions.  This exemption provision will benefit only in case the amount of sale/redemption  proceeds are substantial as investment in a house requires substantial sum of money.

The writer is tax and Investment expert. He can be reached at [email protected] and @jainbalwant on twitter