Taxation of Convertible Bonds: Rules and Capital Gains

Introduction: This article navigates the taxation landscape surrounding convertible bonds, a unique financial instrument offering bond-holders the option to convert bonds into equity shares. Understanding the tax implications is crucial for investors and companies alike, as the conversion process and subsequent sales are subject to specific rules under the Income Tax Act, 1961.

Meaning of Convertible Bonds: 

A bond is a financial instrument that provides periodic interest and a redemption amount at maturity. Convertible Bonds allow bond-holders to convert their bonds into equity shares of the issuing company.

Taxability of Convertible Bonds:

According to section 2(47) of the Income Tax Act, 1961, ‘Transfer‘ includes the exchange of assets. Any conversion of bonds into shares or any other asset is considered an “exchange” and falls within the definition of transfer.

As per Section 45, “any profits or gains arising from the transfer of a capital asset effected in the previous year will be chargeable to income-tax under the head Capital Gains.“

Since bonds are treated as capital assets, capital gains will arise from such transfers, and consequently, capital gain tax shall be charged on such transfer.

However, section 47 of the Income Tax Act, 1961, specifically excludes certain types of transfers from the scope of the word “transfer.” Therefore, no capital gain shall arise from the conversion of bonds into shares or debentures of the company.

Although the conversion of bonds into shares or debentures is not treated as a transfer, when such converted shares or debentures are subsequently sold, the sale is considered a “transfer.” Capital gain tax will be charged at the time of the sale of these converted shares or debentures.

When computing capital gains at the time of the above sale, the cost of acquisition shall be that of the bonds (not the conversion value), and the period of holding shall be reckoned from the date of acquisition of the bonds (and not from the date of conversion).

Conclusion:

In conclusion, while the conversion of bonds into shares or debentures is not initially considered a transfer, the subsequent sale triggers capital gain tax. Investors and companies must be mindful of the intricacies involved in calculating capital gains, considering the original bond value and acquisition date. This article serves as a guide to navigate the taxation nuances associated with convertible bonds, ensuring informed decision-making in financial transactions.