Taxation of Bonds and Debentures under Income Tax Act 1961

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TaxClue Team
TaxClue Team
Taxclue is an online news portal for reporting all news, articles, judgments, Circulars, orders, and notifications relating to various corporate and tax laws in India. We use the tagline ‘Simplifying Laws’. Our mission is to Simplify the Laws and make people aware of their rights and duties in relation to tax matters in order to equip them to participate in nation-building.

Any revenue made on the sale of an investment normally stated as a capital asset under the income tax laws becomes taxable as short term or long term capital gains depending on the holding period of such assets. Different holding periods, varying from 12 months to 36 months, are prescribed for various class of assets to qualify as long term capital assets. Long term capital gains qualify for a concessional rate of tax as well as are entitled to the exemption if investments are made. The qualifying holding period for debentures and bonds also differs depending on whether the same is listed on a stock exchange or not.

Let us discuss the various provisions of I-T act on taxation of income which arise occasionally 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 a periodic interval (Quarterly or Monthly) or in case of cumulative bonds the interest is payable at the time of maturity of the bond. The interest earned on bonds
is taxable under the head “Income from other Sources” and is taxed at the slab rate applicable to the holder. The interest income on the bonds can be taxed either on receipt basis or on the accrual basis. The method for taxation of such income once adopted has to be followed regularly. In the case of cumulative bonds, it is advisable to approach the interest on the accrual basis to avoid unusually high liability on receipt of large income at the time of maturity of the bond. It may be noted that the difference between the issue price of the bond and the face value of the zero-coupon bonds becomes taxable as capital gains as no coupon rate is specified on such bonds. In the case of tax-free bonds thought interest on such bonds is tax-free but any obligation realized at the time of sale or redemption is taxed as short term capital gains (STGC) or long term capital gains (LTCG) 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 the holder. Normally any profit on sale or redemption will become taxable as long-term if the same has been held for more than 36 months on the date of such sale or redemption. Thus profits made on the sale of bonds shall be taxable 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 place of 36 months for it will be treated as long term. So in the 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 of the benefits associated with long term capital assets.

Tax rates on short term profits and long term profits:-

For any Short Term Capital Gains (LTCG), based on the holding period discussed before, made on bonds either at the time of sale/redemption are taxed at the slab rate applicable to the holder of bonds income which varies between 5% to 30% and surcharge and cess as applicable. But, 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 the amount of such long term capital gains.

It is a bit different in the method for computation of short term and long term capital gains. The short term capital gains (STCG) are computed simply by reducing the cost of acquisition of such bonds from the sale or redemption price. Though, for long term capital gains (LTCG), 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 or redemption. The benefit of inflating your cost of acquisition is available only in respect of Capital Indexed Bonds issued by the Government of India and Sovereign Gold Bonds issued by the Reserve Bank of India (RBI). Similarly, for a non-resident Indian any obligation in the redemption value
of the rupee-denominated bonds of an Indian Company due to variation in Indian currency against the foreign currency is not taxed. In the case of bonds that are listed, the taxpayer has the option to pay tax at 10% of the profits on the sale or redemption of the bond.

However, the decision to pay tax at the concessional rate of 10% in place of 20% is not available for zero-coupon bonds.

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

The taxpayer has an option to avail exclusion on the long term capital gains (LTCG) tax under Section 54F of the I-T Act 1961 by investing the net sale proceeds in buying a residential house subject to fulfillment of certain conditions.

Source: Direct taxation ICAI 2019

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