Taxation of Bonds in India

Bonds allow investors to lend money to companies/governments in exchange for regular interest payments and the return on their primary investment at maturity. They work as fixed-income instruments and provide financial stability. Usually, they are less risky than other investment options. However, you must know how taxes impact your earnings from bonds. Let’s get into more detail on what bonds are, the types of bonds that are prevalent, taxation on bond transactions, and more.

Overview of Bonds

The issuer can be a company or government that pays a fixed or varied interest rate to investors who purchase bonds. Whenever investors buy a bond, they lend money to the issuer. Usually, the interest payments are disbursed at regular intervals, like semi-annually or annually. After the bond matures, the issuer will return the investors' money. 

The common term for bonds is fixed-income instruments. This is because your investment receives fixed payments across the bond's lifespan.

Companies usually sell bonds to fund new projects or ongoing operations, and the government also sells bonds to raise funds.

An investor must first consider the investment horizon and their investment goals. After that, they can consider returns and the bond ratings for the risk assessment. 

Investing in bonds involves generating two forms of income: interest income and capital gain/loss. The most inept income is paid at fixed intervals, such as monthly, quarterly, or semi-annually, whereas capital gain/loss is incurred at the time of sale of bonds before maturity.

Let’s go through the details of various types of bonds.

Types of Bonds

1)  Taxable Bonds:

Interest on taxable bonds is subject to taxation according to the investor's income tax slab rate. Capital Gain/Loss occurs when bonds are sold for more than their purchase price. The taxability of capital gain is different for listed bonds and unlisted bonds. For listed Bonds, if held for 12 months or more, they are treated as LTCG and taxed at 12.5% without indexation; otherwise, they are treated as STCG and taxed at the applicable slab rate.

Unlisted bonds transferred, matured, or redeemed on or after 23 July 2024 shall always be considered STCG irrespective of the period of holding, as provided in section 50AA, and taxed at the applicable slab rate of taxpayers.

Let's take an example with statistics to understand better how taxable bonds work. Suppose you invested ₹3,00,000 in a taxable listed bond at a 10% interest rate with five years of maturity. So, you earn ₹30,000 per year as interest, which is credited to your total income and is taxed according to the income tax slab. In capital gains, the listed bonds' taxation differs based on the holding tenure. If the bond's maturity value is ₹6,00,000, the capital gains would be Rs.3,00,000. Since it is a listed bond held for over a year, the capital gains are taxed at 12.5% and 4% cess, excluding an indexation benefit.

2) Tax-saving Bonds:

As the name suggests, Tax Savings Bonds offer special tax benefits to investors. The government has several systems to ensure that taxes do not overburden citizens, and tax savings bonds are one way to save on taxes. The principal repayment on such bonds is exempt.

The interest income generated on these bonds is taxable based on the investor's income tax slab rate. The capital gains are taxed according to the holding tenure (LTCG) because a lock-in period applies to these bonds.

3) Tax-Free Bonds:

Tax–free bonds are a reasonably safe investment choice that allows investors to earn pre-fixed interest each year. Additionally, investors can save money because the interest they earn is tax-free. The principal amount is returned upon maturity. Tax-free Bonds are suitable for investors with a low-risk appetite and a longer investment horizon. Generally, the amount raised from these bonds is utilised to finance critical projects like highways, railways, urban and rural development, etc.  

4) Zero-Coupon Bonds:

The interest generated on a bond is called a coupon. Zero-coupon bonds don’t pay periodic interest; they are issued at a discount rate of their face value and then traded at full face value once maturity is reached. 

Note: Any profit from selling these bonds might be subject to taxation based on the holding tenure. Since there is no interest, no taxes are levied—generally, NABARD, Rural Electrification Corporation (REC), etc., issue zero-coupon bonds.

Zero-coupon bonds held for less than 12 months shall be subject to Short-term capital gain/loss; if held for more than 12 months, they are taxable as long-term capital gain/loss. LTCG is taxable at a rate of 12.5% without Indexation, and STCG is taxable at the applicable slab rate of a person.

Let’s take an example to understand these bonds better. Suppose you have invested in these bonds with a face value of ₹40,000, and the issue price is ₹15,000. So, you receive a discount of ₹25,000. Once the bond reaches maturity, you will get the total amount, i.e. ₹40,000. The income from Zero-coupon bonds (not being held as stock-in-trade) will be treated as capital gains.

TDS on Bonds

As per Section 193 of the Income Tax Act, 1961, all interest income generated from bonds will be subject to TDS (Tax Deducted at Source). TDS will be deducted from the interest income at the rate of 10% for all listed and unlisted bonds. 

Conclusion

Bonds offer consistent and stable returns to investors. Understanding the tax implications of various types of bonds helps them streamline financial planning. By thoroughly understanding the fundamentals of the taxation of bonds, investors can make conscious decisions that meet their requirements and enhance their investment tactics. Investors can seek advice from a financial advisor and get tailored guidance if any doubt arises.