Bond taxation laws in India

Bond investing in India might not be very popular, but that doesn’t mean it doesn’t exist. For conservative investors who prefer to preserve their capital against inflation, get a risk-free return on their cash, and generate passive cash flows, bond investing can be a fool proof plan.

In this article, we’re going to explore what kind of tax liabilities you would incur if you bought bonds in India, and how they differ depending on which type.

But before that, let’s go through a quick refresher on bond investing.

What is bond investing?

Bond investing is like lending money to a borrower, like the government or a company, and getting paid back with interest over time. Think of it as a steady stream of income, like rent from a property you own. 

You buy a bond for a certain price, and the borrower promises to pay you back that amount (the principal) plus interest at regular intervals. 

Bonds are generally considered less risky than stocks because you’re guaranteed to get your money back (unless the borrower defaults). Due to less risk, they’re also less lucrative than equity investments. However, most investors use bond investments to add some stability to their investments.

Types of bonds

There are many different types of bonds, each with its own risks and rewards. Some common types include:

• Government bonds: These are issued by the government and are considered the safest type of bond. Different governments around the world have different credit ratings depending on their riskiness.
• Corporate bonds: These are issued by companies, and they are riskier than government bonds, because there is a chance that the company could default.
• Municipal bonds: These are issued by local governments and are generally considered safe, because they are backed by the taxes that the government collects.

Bond taxation and tax rates

Bonds can either be held till maturity or they can be sold in secondary markets before maturity.

When you sell a bond before maturity, the difference between the sale price and your purchase price is classified as capital gain. Taxation depends on the corresponding holding period:

• Short-term capital gains (STCG) – applies to bonds held for less than 24 months. Taxed at your applicable income tax slab rate.
• Long-term capital gains (LTCG) – applies to bonds held for 24 months or more. Currently taxed at a flat rate of 20% with the benefit of indexation.

Taxation also depends on the kind of bonds you’re investing in:

• Government bonds: Interest earned on government bonds is fully taxable at your income tax slab rate. However, specific tax-exempt government bonds like Savings Bonds (80C deduction) and Kisan Vikas Patra (tax-free at maturity) offer alternative avenues too.
  
• Corporate bonds: Interest income from corporate bonds falls under regular taxation rules also. However, certain bonds like Debenture Redemption Reserves (DRR) bonds with specific lock-in periods might offer deferred tax liability on interest income.
  
• Tax-free bonds: Tax-free bonds such as State Development Loans (SDLs) and Municipal Bonds, offer interest income exempt from income tax.

Example of bond tax calculation

Suppose person X invests ₹10,000 in a bond. After 36 months, X sells the bond in secondary markets for ₹12,000. This creates a long-term capital gain of ₹2,000 for X. However, this will be adjusted for inflation during this 36-month period. Suppose inflation adjusted gains come out to be ₹1,500. Hence, long-term capital gains of 20% would be applied on ₹1,500, which comes out to ₹300.

Strategies to save tax liability

Here are some ways in which you can save yourself some tax by adjusting your bond investment strategy:

• Staggered investments: One strategy is to spread your bond investments across different tenures to manage your tax liability better, strategically utilising both LTCG and STCG benefits.
  
• Tax-free bonds: For the long-term, you could also consider dedicating some portion of your portfolio to tax-free bonds.
  
• Get smart on exemptions: Take advantage of schemes like 54EC bonds to shield capital gains from other assets from LTCG tax.

Frequently Asked Questions