Tax Treatment of Tax Free Bonds

Tax free bonds have emerged as a popular way of investment in India due to the lucrative taxation benefits they offer. The interest income on these bonds, generally issued by government enterprises, is exempted from taxation. For a better understanding lets probe it:

What are Tax Free Bonds?

When you purchase a bond, it implies that you are lending money to an organization for which you will be paid a Fixed Rate of interest during its tenure. And when the government notifies that interest earned on it will not be taxed then it is called Tax Free Bond.

Tax free bonds in India are issued by government of India or PSU’s for a fix term say 10 years, 15 years, 20 years etc. Further these bonds shall be rated by agencies like CARE, FITCH, CRISIL; ICRA enables you to assess the quality of instruments. Since interest received is tax free so after tax returns works out to be higher. Some of the public undertakings that will be raising funds are IIFC, IRFC, PFC, NHAI, HUDCO, REC, NTPC, NHPC, Indian Renewable Energy Development Agency, Airports Authority of India and Cochin Shipyard.

Return on tax free Bonds

The general prevailing rates of interest on the tax free bonds are from 8% to 9% depending upon the type and tenure of Bonds. It is pertinent to note that since these are tax free so effective Tax equivalent yield on 8% investment comes out to be 12.14%, 10.63%, 9.44% for 30%, 20% and 10% Tax bracket respectively.

How to invest in tax free bonds?

Investor may apply in Demat as well as Physical Mode with required documents as mentioned in the respective prospectus.

Advantages of Tax free Bonds

  1. Tax Free Income:The interest earned on tax free bonds is not subject to any taxation and hence they are known as tax-free bonds.
  2. Tax Free Bonds can be traded:Tax-free bonds are listed on National Stock Exchange and Bombay Stock Exchange for trading and one can easily sell them off in secondary market before the end of the tenure without suffering any penalty.
  3. Price of Bonds may increase:Prices of bonds may fluctuate with interest rates. If interest rates goes up then the Price of Bond may come down and vice versa. So, if one invests in tax-free bonds and interest rate goes down, one can then easily sell the bonds at a higher price. This surplus amount earned is known as capital gain.

Tax treatment of tax free bonds

  1. Interest Income:The interest earned from tax free bonds is exempt from Income Tax under Section 10(15)(iv)(h) of the Income Tax Act, 1961.
  2. Maturity Amount of a tax free bond:The amount received at the expiry of the tenure of a tax free bond will not be subject to any tax..
  3. Capital Gain earned from tax free bonds: Tax free bonds can be sold in NSE or BSE. The profit accrued after selling tax free bonds at higher rates comes under capital gain.

While short term capital gains from such a sale will be taxed as normal Income Tax Slab rates, long-term capital gains will be taxed at 10%. The bonds must be held for at least 12 months for the profits to be treated as long-term gains. Unfortunately for investors, the long-term capital gains from these bonds are not eligible for indexation benefit which could have reduced tax.

Thus here we find a good number of reasons for all not to miss current issues of Tax free bonds for their higher post tax returns and that too especially for the group falling in higher tax brackets. Say the post tax return for a 30% tax bracket will settle for around 12.14% which is only 8-9% in case of FDRs. The only flipside for some investors is that since the payout of the interest is yearly so the interest does not get reinvested as compared to FDR. Hence, a fine tune balance can help you gain maximum out of this attractive investment option.

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