Taxation on Bonds in India: Bond Type & Taxation

Taxation of Bonds

When investors allocate funds to bonds, they weigh various factors like coupon payments, lock-in periods, and more. However, taxation stands out as the most crucial aspect to consider when investing in these financial instruments.  In India, each type of bond is subject to its own specific tax regulations and Investors can generate income from bonds through two primary channels: interest payments and capital gains. 

Here’s a look at how different bonds are taxed in India:

Regular Taxable Bonds

As the name implies, taxable bonds are subject to taxation. Investors can earn from these bonds in two ways: through interest payments and capital gains.

Capital gains refer to the profit made by an investor when the bond matures, calculated as the difference between the bond’s purchase price and its sale price.

Interest earned on bonds is added to the investor's gross total income (GTI) and taxed according to the applicable income tax slab.

For instance, if Mr. Joshi invests ₹10,00,000 in a taxable bond with a 10% annual interest rate, his interest income would be ₹1,00,000, which would be added to his GTI and taxed accordingly.

Capital gains on these bonds are classified into two categories: long-term capital gains (LTCG) and short-term capital gains (STCG). For listed bonds, if the holding period exceeds 12 months, the gains are considered LTCG and are taxed at 10% without indexation. If the holding period is 12 months or less, the gains are categorized as STCG and taxed at the applicable income tax slab rate.

For unlisted bonds, if the holding period is more than 36 months, the gains are treated as LTCG and taxed at 20% without indexation. If the holding period is 36 months or less, the gains are considered STCG and taxed according to the applicable tax slab.

Tax-free Bonds

Governments and Public Sector Undertakings (PSUs) issue these bonds to generate funds for key national projects. The funds raised through tax-free bonds are typically used for infrastructure development, social welfare initiatives, and projects like highways, railways, ports, and urban and rural development.

Interest earned from these bonds is exempt from tax. However, any gains realized from the sale or maturity of these bonds are subject to taxation, classified as either long-term or short-term capital gains based on the holding period.

Tax-saving Bonds

Individuals who own long-term capital assets like land or buildings can reduce their tax liability by investing in 54EC bonds. By investing the proceeds from the sale of these assets into 54EC bonds, they can enjoy a 100% exemption on long-term capital gains (LTCG). However, this tax benefit is only available if the investment is made within six months of the asset’s sale. Investors can also earn capital gains from these bonds, which are taxed as either LTCG or short-term capital gains (STCG), depending on the holding period.

Additionally, the government permits a deduction of up to ₹20,000 per year on investments in these bonds, which is in addition to the ₹1.5 lakh deduction available under Section 80C.

54EC bonds can be issued by entities such as NHAI, REC, and PFC.

Zero Coupon Bonds

A coupon refers to the interest that investors earn when they invest in a bond. However, zero-coupon bonds are different; they do not pay any interest but are issued at a significant discount to their face value. The investor receives the bond's full face value upon maturity.

For instance, if Mrs. Jain invests in a zero-coupon bond with a face value of ₹25,000, and the bond is issued at ₹10,000, she benefits from a ₹15,000 discount. Upon maturity, she will receive the full ₹25,000.

Since there are no regular interest payments, there is no tax on interest. However, investors can still earn capital gains, which are taxed as either long-term or short-term capital gains, depending on the holding period. Zero-coupon bonds can be issued by NABARD, REC, and certain government bodies.

Final Thoughts

Bonds are relatively low-risk investment options that can provide steady and consistent returns. However, it is essential for investors to carefully assess the tax implications of different bonds and stay informed about any changes in tax regulations before making an investment decision.