Is Tax Deductible at Source (TDS) Applicable on the Bond?

bonds have become the go-to investment option for investors who want to limit the losses from other investments by earning a regular interest on the principal amount they invest in bonds. However, as earnings from almost all the sources contribute to the total taxable income, bonds do carry an obligation to pay taxes on the income earned. If you are looking to invest in Bonds, it is vital to understand the tax on bonds in India and the tax treatment on bonds to make better investment decisions.

What are Bonds, and how do they work?

Bonds are financial instruments categorised under the asset class of debt. Bonds create a legal agreement between the issuer and the buyer to allow the issuer to raise a certain amount of funds. Governments or private organisations issue bonds to raise capital while the buyers invest their capital to receive regular interest payments on the principal amount. The bond agreement details the terms of payment (debt servicing) and maturity. These come with a face value (principal) to be repaid on maturity and can be issued either at a discount or a premium.

Bonds are fixed tenure debt instruments issued to finance specific projects by the issuer. The interest (based on coupon rate) is paid in pre-defined instalments to the bondholder until maturity. Bond prices are inversely proportional to market interest rates and dependent on various factors such as the credibility of the issuer, maturity, and interest rates in the market.

Bonds work similar to a loan agreement where the bank is the buyer (investor), and the customer is the issuer (government or corporate entity). The issuer wants to raise money for funding certain business operations and deems it fit to raise capital through issuing bonds. When an investor buys bonds, they receive regular interest payments from the issuer with the promise that their principal amount will be repaid at the time of maturity. Furthermore, investors can also trade using the bonds and sell them anytime before maturity to realise profits based on the difference in the cost and the selling price.

Calculation of Taxable Income: Is Tax Deductible at Source applicable on bonds?

Almost every income you earn is added to the total taxable income on which you have to pay taxes based on the applicable income tax slab. The Income-tax slabs to calculate your taxes are as follows:

The above tax slabs are applicable to the income you earn from various sources. However, the government has also created a system of Tax Deductible At Source (TDS) to create a transparent process for levying tax on bonds and ensure the tax treatment on bonds is systematic.

For bonds tax, the government has directed the issuer of the bonds to deduct TDS at 10% on the interest paid on bonds under Section 193 of the Income Tax Act, 1961. The provision of tax on bonds in India also extends to bonds issued by the government, called G-secs along with corporate bonds issued by the private organisations. However, in case the bonds are tax-free bonds, the provision of tax on bonds ceases to apply.

What are Tax-Free Bonds?

A government organisation or enterprise issues tax-free bonds to raise funds for specific purposes. Tax-free bonds work similar to other bonds and have a fixed coupon rate, and provide a regular interest payment to the bondholder. As the government issues these types of bonds, they have a rare chance of default and allow for a low-risk investment option

The unique feature of tax-free bonds is their ability to offer tax-free interest payments to the bondholders. The interest received by the bondholders is tax-exempted under Section 10 of the Income Tax Act, 2961. There is no provision for Tax Deductible at Source for the interest payments, and the bondholders do not have to pay tax on the interest received. Such bonds come with a higher maturity period of ten years or more.

What are the Commonly found Tax-Free Bonds?

Tax-free bonds ensure that tax on bonds is not extended to the interest payments and that the tax treatment on bonds is limited. Here are the commonly found tax-free bonds in India:

• Sovereign Gold Bonds: Sovereign Gold Bonds are a type of bond that provides an alternative to purchasing physical gold as tradable security. The Reserve Bank of India introduced Sovereign Gold Bonds in 2015 to allow investors who want to make profits based on the price fluctuations of physical gold to make profits without having to buy physical gold. The Reserve Bank of India issues Sovereign Gold Bonds on behalf of the Indian government, denominated in grams of gold.

• IRFC Tax-Free Bonds: The Indian Railways Finance Corporation tax-free bonds come with a face value of Rs 1,000 and are issued in two series, series-80 (10 years) and series 80A (15 years). The bonds offer an 8% interest rate, and the interest earned is tax-free as there is no interest tax on bonds.

• Capital Gains Bonds by REC and NHAI: These types of bonds issued by the REC and NHAI allow investors to save the tax levied on the sale of long-term capital assets. If you invest the amount after the sale of long-term capital assets within six months into the capital gains bonds, the amount is exempted from the long-term capital gains tax. The provision of such exemption is under Section 54EC of the Income Tax Act, 1961.

Tax-Free Bonds and Tax-Saving Bonds

Investors get confused between tax-free bonds and tax-saving bonds as the tax treatment on bonds is different for both. Tax-free bonds allow for tax exemptions on the interest amount. If you invest in tax-free bonds, you do not have to pay taxes on the earned interest but on any profits realised as the end result of the bond. However, tax-saving bonds include the interest tax on bonds provision, where the interest paid is taxable in the hands of the bondholder, but the end results are not taxed.

Final Word

Bonds are one of the most effective financial instruments available for earning regular income based on interest payments. However, as there is a tax on bonds in India, it is important that you understand everything about the bonds tax and the tax treatment on bonds. You can create an improved debt portfolio by including both the tax-free and tax-saving bonds to receive regular interest payments and save tax at the same time.