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Zero coupons work if tax treatment is fair

Zero coupons work if tax treatment is fair
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First Published: Wed, Mar 17 2010. 09 10 PM IST

Updated: Wed, Mar 17 2010. 09 10 PM IST
Ooccasionally, one comes across certain debt instruments that do not bear any interest, but are issued at a discount and redeemed at face value, or are issued at face value and redeemed at a premium. In such cases, the question that an investor faces is: how is the discount or premium to be taxed? Is it taxable as interest or as capital gains? Is it taxable on a year-on-year basis or on maturity?
Earlier, there was no express provision under the Indian tax laws nor any Indian case law dealing with this aspect. The Court of Appeals in England (in the case of Lomax v. Peter Dixon and Son Ltd in 1944) lays down the following principles for taxation of such discount or premium:
* Where a loan is made at or above a reasonable commercial rate of interest considering the security, the “discount” or “premium” is not in the nature of interest.
* The true nature of the “discount” or the “premium” is to be ascertained from all the circumstances of the case and interpretation of the contract.
* In deciding the true nature of “discount” or “premium”, the matters to be considered are the terms of the loan, the rate of interest expressly stipulated for, the nature of the capital risk, the extent to which the parties took the capital risk into account in fixing the terms of the contract.
The general principle for debt instruments is that the investor is entitled to interest on his money. If the instrument does not stipulate any rate of interest, the presumption would be that the discount or premium is in the nature of interest.
The Central Board of Direct Taxes (CBDT) had initially clarified, through letters sent to issuers of such instruments, that such difference would be taxed as interest income. In 2002, CBDT issued a circular, clarifying that the income on such bonds was taxable annually by computing the difference between the market prices of such instruments at the end of the year and at the end of the preceding year, and treating such difference as interest income of the year. Of course, this meant that the quantum of interest income could vary drastically every year due to fluctuation in the rate of interest, causing change in market valuations.
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An exception was made by incorporating notified zero-coupon bonds in tax laws from 2005. Such bonds could be issued by an infrastructure capital firm or fund, or by a public sector firm or by a scheduled bank, and would be notified by CBDT. In case of such bonds, the discount or premium will be taxed as capital gains and not as interest. Long-term capital gains on such bonds would be taxed at a concessional rate of tax—the lower of 20% of the gains computed with indexation of cost, or 10% of the gains computed without indexation of cost.
The tax on such discount can’t exceed 10% as opposed to a tax which may go up to 30% if such discount had been taxed as interest. The second advantage is that the tax on income from such bonds doesn’t have to be paid each year, but only on its maturity or sale.
Effectively, there are two types of zero-coupon bonds— notified, which are entitled to preferential tax treatment of discount as capital gains; and those that do not get such favourable tax treatment.
One example of such a notified zero-coupon bond is the Bhavishya Nirman Bond, being issued by the National Bank for Agriculture and Rural Development, which is currently available. These bonds have a face value of Rs20,000, are being issued at a discount at Rs9,750 and will be redeemed at face value at the end of 10 years. If one computes the inherent rate of interest in such bonds, it works out to only 7.45%. However, the post-tax return on such bonds is a fairly decent 6.7%, if one deducts 10% tax thereon.
The difficulty that one faces in taking a decision to invest in notified zero-coupon bonds is due to the uncertainty caused by the direct taxes code (DTC). Though the draft DTC provides for taxation of discount on such bonds as capital gains, it does not have a concessional tax rate for long-term capital gains on zero-coupon bonds. So, one is left wondering whether one would end up paying tax at 20% or 30% on the discount on maturity of such bonds instead of the anticipated 10%. The post-tax rate of return is, therefore, uncertain. One wishes there was clarity, certainty and stability in tax laws.
Gautam Nayak is a chartered accountant. Your comments, questions and reactions to this column are welcome at feedback@livemint.com
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First Published: Wed, Mar 17 2010. 09 10 PM IST