Under Income Tax Act, 1961, Income derived from gain on sale of shares, debentures, bonds etc. attracts taxability under the head of “Capital Gains”. Such gain is either taxable as short term capital gain or long term capital gain. In this article, we will discuss the concept of “Zero Coupon Bonds” and throw light on taxing aspects of zero coupon bonds and understand the manner in which these are treated under Income Tax in India.
What is Zero Coupon Bonds
Generally, bonds are issued at face value and a fixed interest is paid on them. But in case of Zero-Coupon Bonds, no interest is paid to the holder. Rather, such bonds are issued at a heavy discount on the face value of the bond. On maturity, the bondholder gets back the face value of the bond. These bonds are therefore, also known as ‘Discount Bonds’. For example: - Suppose Face Value of the bond is Rs. 100 to be matured after 5 years. It is issued at Rs. 70. Thus, the bondholder initially pays Rs. 70. After 5 years, he will get back Rs. 100. The difference of Rs. 30 may be termed as interest for the 5 years.
The term “Zero Coupon Bond” has been defined by Section-2(48) of the Income Tax Act as below: -
“Zero Coupon bond” means a bond: -
(a) issued by any infrastructure capital company or infrastructure capital fund or public sector company or scheduled bank on or after the 1st day of June, 2005
(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
(c) which the Central Government may, by notification in the Official Gazette, specify in this behalf.
Who should invest in Zero Coupon Bonds?
Zero Coupon Bonds are meant for those investors who want to avoid market risk involved in the share market. Zero Coupon Bonds assures a fixed maturity amount after a certain period. Therefore, the investors who have want to get a fixed return in future with less market risk should go for these bonds. Even if you are an aggressive investor and always hunting for good stocks, you may still invest in these bonds to balance your portfolio.
What are the benefits of investing in Zero Coupon Bonds?
Zero Coupon Bonds carries lesser risk with fixed income option. The return on these bonds is comparably higher as compared to other fixed income options. Further, the most important advantage of the zero coupon bonds is that no tax is payable on interest element if you invest in notified zero coupon bonds. These are subject to capital gains tax only.
What is the tax implication of Zero-Coupon Bonds?
- Unlike other bonds or debentures, investment in zero coupon bonds does not give any periodic return. Therefore, annual interest cannot be taxed on accrual basis in this case like other bonds or debentures.
- Under Income Tax Act, gains on sale of any securities shall be taxable as long term or short-term capital gains depending on the holding period. For this purpose, holding period of 12 months to 36 months have been prescribed for different category of assets for being classified as “Long Term Capital Asset”.
- In case of bonds & debentures, holding period of 36 months is considered for classification as “Long Term Capital Asset”. Thus, any gain on sale of bonds shall be considered as ‘Short Term’ if these are held for a period less than 36 months. If the holding period is more than 36 months, the same shall be considered as ‘Long Term’.
- If there is short term capital gain on sale of bonds, such gain shall be taxable at the slab rate applicable to your income varying between 5% to 30% plus surcharge & cess.
- In case of long-term gain on notified zero coupon bonds, the investor shall pay capital gain tax on maturity. Such capital gain tax is payable on the difference of maturity price and the purchase price.
- Proviso to Section 112(1) prescribes the manner of calculating tax on long term capital gain on zero coupon bonds. According to this proviso, tax on long term capital gain on zero coupon bonds shall be lower of the following: -
(a) Tax on capital gains computed normally @ 20% on difference of maturity price and purchase price (indexed) or
(b) Tax on capital gains computed @ 10% on difference of maturity price and purchase price, without giving benefit of indexation.
How will discount be treated in the hands of issuer company?
- There is a specific provision under section 36(iiia) of the Income Tax Act which states that the issuer company can claim discount (difference of maturity price and issue price) as an expenditure on pro-rate basis over the maturity period.
- TDS provisions are not applicable on redemption proceeds of zero coupon bonds.
