Bonds offer interest and capital appreciation to investors. It is better to know the basis of taxation and the rate of tax.
Returns from investments in bonds come from interest receipts and capital appreciation. The bulk of the returns come from interest payments which is fixed, as against capital gains, which is uncertain and a relatively smaller component of the overall returns from a bond. Price appreciation is not only a relatively smaller component but also, till it is booked, it remains on paper only. The interest (technically known as coupon) inflow is taxed at the marginal slab rate, which at the higher end is 30% plus surcharge (as applicable) and cess. Price appreciation is taxed as capital gains; long term if held for more than one year for a listed bond and three years for an unlisted bond. For listed bonds held for more than one year, long term capital gains tax is 10% plus surcharge (as applicable) and cess.
If the cash flows from the issuer of the bond to the investor is treated as capital appreciation instead of coupon, there would be tax efficiency. In zero coupon bonds, where there is no interest payment in the interim from issue to maturity, there is a case for treating it as capital appreciation. There are certain notified zero-coupon bonds, issued by NABARD and REC, where the differential between maturity price and issue price is treated as capital appreciation and taxed accordingly. Hence in the NABARD and REC notified bonds, entire price appreciation is treated as LTCG for a holding period of more than one year. This generates considerable tax efficiency, taxation rate being 10% as against 30%.
For other non-interest paying bonds, which may also be termed as zero coupon or ‘redemption at a premium’ or ‘issue at a discount’, gains are taxed as interest rather than capital appreciation. Going by provisions of the law, for plain vanilla non-notified zero coupon bonds, the differential between issue price and maturity value is taxable as interest. However, investors in such bonds may get in touch with his/her tax consultant as there may be scope for generating tax efficiency in non-coupon paying bonds by treating it as capital gains, based on precedence.
Capital gains can be set-off against capital loss. LTCG from selling a listed bond after a holding period of more than one year, can be set off against long term capital loss from say debt mutual fund or unlisted equity. While as per theory it can be set off against long term capital loss from debt mutual fund, it is highly unlikely that over a holding period of 3 years debt would give negative returns. Loss from unlisted equity is a more probable method for setting off.