What are tax-free bonds and how they work

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What are tax-free bonds and how they work

31 December 2016
Let's see what these bonds are and how they work.
 
 

By Sunil Dhawan

Indian investors seem to be spoilt for choice when it comes to investing. From investment schemes offering monthly, quarterly, half-yearly as well as annual returns, to schemes offering taxable as well as non-taxable returns, the list is endless. Choosing the right investment avenue, therefore, may not be as easy as it appears. One of the hugely-popular investment options, especially among high net worth investors, is tax-free bond. Let's see what these bonds are and how they work.

What are they: A bond is a fixed income instrument carrying a coupon rate of interest and is issued for a fixed tenure. As the name suggests, interest earned from tax-free bonds is exempt from tax. In simple terms, irrespective of the income slab one need not pay any income tax on the interest income. Some of the public undertakings which raise funds through the issue of tax-free bonds are IRFC, PFC, NHAI, HUDCO, REC, NTPC, and Indian Renewable Energy Development Agency.

The tenure of the bonds is usually 10/15 or even 20 years. They are also listed on stock exchanges to offer an exit route to investors. The bonds are tax-free, secured, redeemable and non-convertible in nature.

Tax status: The interest income earned is exempt from tax under Section 10 (15) (iv) (h) of the Income Tax Act, 1961. There will, however, not be any tax benefit on the amount of investment made in such bonds. Also, there is no applicability of TDS on interest income. TDS applicability will still be there on the application money while applying for them.

Such bonds are also listed on stock exchanges and traded only through demat accounts. If there is any capital gain on transferring them on exchanges, that will be taxed. If the holding period is less than 12 months, capital gains on sale of tax-free bonds on stock exchanges are taxed as per the tax rate of the investor. If bonds are held for more than 12 months, the gains are taxed at 10.3 per cent. There will not be any benefit of indexation in them.

Related: Tax benefits after retirement

The pluses: Tax-free bonds are hugely popular with high net worth investors because they allow parking a huge lump sum at one place. They are perceived to be relatively safe as they are primarily issued by government institutions and carry high investment grade ratings. Also, the effective pre-tax yield is high for those in the higher income slab. Although tax-free bonds are low-risk products, the effective pre-tax yield appears to be high. Anil Rego, CEO & Founder, Right Horizons says, "If we look at tax-free bonds from financial planning per se, though it is a low-risk asset class but even an investor with a high-risk profile can invest in them because the returns are tax-free and hence if worked backwards, then the post-tax returns would be quite high. This enables an investor to not only earn tax-free income but also ensure safety of capital."

Suits those in higher tax slab: The tax-free nature of bonds suits those in the highest tax slab paying 30.9 per cent tax on their income. Say, a bank deposit carries 7.5 per cent return on it. As the interest on fixed deposit is fully taxable, the income gets added to one's total income. Therefore, for someone paying 30.9 per cent tax, the net income will be 5.18 per cent, a tad higher than what savings accounts offer.

What it means: It means for someone paying tax of 30.9 percent, investing in a taxable investment yielding not less than 8.68 percent return will make sense. A taxable investment yielding 8.68 percent return will fall to 6 per cent post-tax of 30.9 per cent. However, in reality, bank deposits currently are offering around 7.5 per cent (taxable) return even on deposits of ten years. Even someone paying 20.6 per cent tax may find these tax-free bonds suitable.

How they work: The interest that an issuer can offer to investors depends on the yield of government securities prevailing around the time of issuance. Once set and offered, it will remain fixed for the entire tenure. The interest rate will depend on two factors - One, on the ratings of the issuer and secondly, whether the investor is a retail or a high net worth investor.

For tax-free bonds rated AAA, the interest rate for retail investors will be 0.5 per cent lower than the G-sec rate and 0.8 per cent lower for all other investors. For tax-free bonds rated AA+, the interest rate will be 0.10 per cent higher than AAA-rated issuers and for tax-free bonds rated AA or AA-, the interest rate will be 0.20 per cent higher than AAA-rated issuers.

Retail individual investor is one who is investing up to Rs 10 lakh in each issue, including NRI's (on repatriation or non-repatriation basis), while those investing above Rs 10 lakh are considered high net worth individuals.

The minuses: The tenure of tax-free bonds being long term, one should carefully invest in them keeping intermittent goals in mind. Invest in them only if you are sure not to use the funds for such a long period.

Liquidity is low in tax-free bonds. Usually, they are listed on stock exchanges to provide an exit route to investors. Price and volume may play a spoilsport while off-loading them.

Further, frequency of interest payment in tax-free bonds is generally annual. For half-yearly interest payment, the rate is generally reduced by 0.15 per cent. Unless interest income is put to good use, by say, diverting it towards long-term market-linked investments, the entire tax-free investment may not yield optimum result. Rego says, "In case one has opted for a cumulative interest payout, i.e. payouts along with the capital on maturity, the same can be utilised to meet the required goal."

Conclusion: Tax-free bonds may not be ideal to create wealth in order to meet long-term goals such as child education, marriage or retirement. They primarily help one to keep one's tax liability at bay. Therefore, invest in them after properly evaluating your tax rate, tax liability and long-term needs.

(Readers are advised to consult their tax advisor for detailed advice.)

Source: Economic Times

 

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