Bonds can be differentiated in the way they earn income for you. On one hand we have simple annual coupon bearing bonds that pay you interest on a fixed date every year till maturity; while on the other hand, we have cumulative coupon bonds which ensure that your interest too earns interest and pay you the final accrual at the end of the tenure.
Then we have Deep Discount Bonds (also called Zero Coupon Bonds or Pure Discount Securities) that are issued at a discount and pay you face value at maturity.
Given below is the tax treatment on income from each of these Bonds:
1. Interest Paying Bonds:
Tax treatment of the annual interest paying bonds is the simplest of all. The interest earned on these Bonds is taxed under ‘Income from other sources’ if the Bonds are held as Investments or under ‘Business Income’ if they are held as trading assets.
The interest is to be offered to tax in the year of receipt or accrual (say, the interest may accrue on March 31 of the year but would actually be received early next year), as per the method of accounting followed by the investor. The tax rates are the usual slab rates for an individual assessee and the corporate tax rates for a company.
2. Cumulative Interest Paying Bonds:
In the case of Cumulative Interest paying bonds too, the Interest is earned at a specific coupon date every year until maturity. However, unlike the annual interest paying bonds, this interest is added to the principal and thus earns further interest. The total interest earned on the Bond is then paid out in lump sum at the time of maturity.
The interest earned on these Bonds is also taxed under ‘Income from other sources’ if the Bonds are held as Investments or under ‘Business Income’ if they are held as trading assets. The interest is to be offered to tax in the year of receipt or accrual (i.e. every year or in toto at maturity), as per the method of accounting followed by the investor. The tax rates are the usual slab rates for an individual assessee.
Redemption of the Annual or Cumulative Interest paying Bonds may be at par or at premium. If the Bonds are redeemed at par, there would be no tax implications on redemption of the Bond. If however, the Bonds are redeemed at a premium, they would entail a Capital Gain Tax.
The tax will have to be calculated without availing the benefit of indexation. No Indexation benefit is available on Bonds (other than capital-indexed bonds issued by the Government) as per the Third Provision to Section 48 of the Income Tax Act, 1961.
Sale or Purchase in Secondary Market:
In case the Bonds are sold by the original buyer in the secondary market instead of holding it till maturity, the traded price of the Bond would consist of three main parts:
I. The Par Value of the Bond
II. Premium or Discount to par value.
III. Interest accrued till the date of sale or purchase from the last coupon date.
For the seller, the premium (or discount) on sale of the Bond will result into Capital Gain (or Loss) and the tax treatment would be the same as in the case of redemption. The Interest accrued till the date of sale would be the income of the seller and would entail the usual tax treatment applicable for interest stated above.
For the Buyer, the Par value of the Bond together with its premium or discount would become his purchase cost. It would be taken into consideration at the time of calculation of Capital Gain on the subsequent sale or redemption of the Bond by the buyer. The accrued interest paid by him to the seller would be reduced from the Interest received for that year (or directly at the time of sale or redemption in the case of cumulative interest Bonds).
3. Zero Coupon Bonds (Aka Deep Discount Bonds):
In India, certain types of Zero Coupon Bonds have been classified as Deep Discount Bonds by the Income Tax Department for the purpose of tax treatment. The tax treatment of these Deep Discount Bonds differs slightly from the tax treatment of other Zero Coupon Bonds.
Deep Discount Bonds are those that are issued at a discount and redeemed at par value.
A person holding a deep discount Bond is required to make a market valuation of the Bond as on March 31 of each Financial Year (Valuation Date). For the purpose of such valuation, market values of different instruments declared by the Reserve Bank of India (RBI) or by the Primary Dealers Association of India jointly with the Fixed Income Money Market and Derivatives Association of India can be considered; as suggested by the said Circular.
The difference between the market values on two successive valuation dates (or the date of purchase, in case of first year of holding the Bond) is taxable as interest. The interest is to be offered to tax in the year of receipt or accrual (i.e. every year or in toto at maturity), as per the method of accounting followed by the investor. The tax rates are the usual slab rates for an individual assessee.
On redemption/maturity of the Bond, the difference between maturity value and the market value as on the last valuation date immediately before maturity will be treated as interest. The tax treatment is the same as that referred above.
Sale or Purchase in Secondary Market:
If such Deep Discount Bond is sold at any time before maturity, such transaction would be chargeable to Capital Gains Tax. The capital gain for this purpose will be the difference between the sale price of the Bond and its original cost together with the total interest offered to tax till the date of such sale (in other words, the market value as on the valuation date immediately prior to the sale). An important aspect to be kept in mind however is that such gain would always be treated short term capital gains and would be taxed accordingly.
For the buyer of such a Bond, the difference between the market value as on the immediately next valuation date and the price paid by him for the Bond would be treated as Interest for the year in which the bond is purchased. The interest for the subsequent periods will be computed in the same manner as above. The tax treatment of such interest would be the same as mentioned above.
Option to Small Non-Corporate Investors:
You would agree that tax treatment of Deep Discount Bonds can be a rather complex and time consuming process, especially for a small non-corporate investor. To save them the trouble of making market valuations on each valuation date, the Income Tax Department has provided them with a rather simpler way of arriving at the taxable income.
For them, the difference between the issue price and the maturity value is treated as interest income at the time of maturity. However, if the Bonds are transferred before maturity, the difference between the sale price and the issue price will be treated as Capital Gains (or trading loss for a person who deals in the sale and purchase of such bonds).
For this purpose, a small non-corporate investor would be a non-corporate investor holding Deep Discount Bonds up to an aggregate face value of rupees One Lakh.
Special Treatment of Certain Zero Coupon Bonds:
In a departure from the general tax treatment, the Income Tax Act, 1961 has specified a special tax treatment for certain ‘Zero Coupon Bonds’.
For this purpose, Clause (48) of Section 2 of the Income Tax Act, 1961 defines the term ‘Zero Coupon Bond’ as below:
Section 2(48) – “ZERO COUPON bond” means a bond:
b. In respect of which no payment and benefit is received or receivable before maturity or redemption from infrastructure capital company or infrastructure capital fund or public sector company or scheduled bank; and
If all the above conditions are satisfied, income from such ‘Zero Coupon Bond’ will be considered as capital gains. These bonds will be considered as short term capital asset if held for a period of 12 months or less. Long term capital gains on such bonds will attract 10% tax without claiming the benefit of indexation.
Some of the Bonds notified by the Central Government include Zero-Coupon Bonds issued by National Bank of Agriculture and Rural Development (NABARD) and Rural Electrification Corporation (REC).