Bonds are fixed-income investment instruments and they offer capital appreciation in the form of capital gains after maturity.
While a bond’s interest income is taxed at an individual’s slab rate, the capital gains are charged differently. Moreover, there are different types of bonds where some offer tax exemption while others are tax-free. Since they have debt and equity components attached to them, they are taxed differently. As an investor, you need to understand the taxation of bonds.
This blog will explain how different bonds are taxed, the tax treatment of the interest income, and the gains received on redemption or sale of bonds in the secondary market.
How Do Bonds Work?
Before we jump to the taxation of bonds, let us first understand the basics of how bonds work and the kind of income they offer.
Bonds are debt instruments that provide fixed income in the form of interest. Such interest is paid either annually, semi-annually, or compounded and paid at maturity. However, zero-coupon bonds do not offer any interest.
Once you have invested in bonds, either upon redeeming bonds at maturity or on selling them in the secondary market, you will have some profits made out of its buying and selling price, which is called a capital gain. Hence, bonds provide capital appreciation over a period.
Taxation of Bonds
For taxation of bonds, there are primarily two components that are taxed – interest and capital gains.
However, not all bonds offer interest, and that’s exactly why we will first understand the tax treatment of these two components and then discuss the tax treatment of different types of bonds.
Typically, bonds bear an interest rate required to be paid to bondholders at regular intervals depending on the type of bond you are investing your money in.
Such interest income is taxed at an individual’s slab rate. This interest income forms part of, ‘income from other sources’ income head of the return of income.
An important aspect of the interest income is that if the investor decides to receive a cumulative interest amount at the time of maturity, then it may impose colossal tax liability in the year of maturity to the investor. To avoid that, remember to accrue the interest annually even if it will be accumulated and paid after maturity.
2. Capital Gain on Redemption
The bonds are issued at an issue price, and while redeeming the bond units or selling them in the secondary market, the current market value is considered (selling and redeeming bonds). Hence, there is a difference in the issue price and selling price, which is regarded as capital gain.
Capital gain is reported under the income head of, ‘income from capital gains.’ However, the period of holding the bond decides whether the gain is long-term or short-term.
Generally, for listed bonds, any gain after 12 months is considered as a long-term capital gain. Whereas, for unlisted bonds, such period is 36 months, above which the gain is deemed to be long-term.
Short-term capital gain is calculated at the slab rate depending on an individual’s income. Whereas, long-term capital gain is taxed at 10% without indexation or 20% with indexation, plus surcharge.
Types of Bonds and Their Taxation
There are different types of bonds in the market. Let us look at their types and taxation.
1. Zero-Coupon Bonds
Zero-coupon bondholders are liable to only capital gain tax as they do not provide any interest income. However, these are issued at a discount. Hence, the difference is taxed as capital gain.
2. Market-Linked Bonds
Market-linked bonds offer fixed interest, and the interest rates are linked to the index it is tracking. Hence, interest is only paid if the bond’s interest rate is above the index performance level.
Such interest is taxed under the slab rate, ‘Income from Other Sources,’ whereas any capital appreciation that arises is taxed as capital gain under, ‘Income from Capital Gains.’
3. Government or Tax-Free Bonds
Government and Government-backed entities also issue bonds from time to time, and usually, the interest earned from such bonds are tax-free.
In other words, you do not need to pay tax on the interest earned. However, you will be charged a capital gain tax on the capital appreciation upon redemption or sale of these bonds.
Certain government bonds such as sovereign gold bonds are exempted from capital gains tax if they are held until maturity.
4. Section 54EC (Tax-Saving) Bonds
Section 54EC Bonds provide a long-term capital gain exemption from house property or land sale if such investment is made considering certain conditions. The interest income earned on these tax-saving bonds is taxable.
However, you do not need to pay any long-term capital gain, upon maturity, as it is exempted from tax. Such bonds are required to be held for five years, and hence, capital gain tax is not charged on maturity.
5. Corporate Bonds
Companies issue corporate bonds to raise capital in their organizations. They offer considerably higher interest income, but corporate bonds can be secured or unsecured. Hence, there is a risk of losing your money entirely.
The Bottom Line
The taxation of various investment instruments, primarily bonds and debentures, is a bit tricky. Since they have debt and equity elements in their investment, their tax should be understood well before making any investment decision.
We always recommend consulting your financial consultant before investing in such bonds to clarify the amount of tax you will pay and the net returns you can make out of it.