Understanding Taxation of Bonds

Understanding how bond investments are taxed is essential for every investor, whether they are salaried professionals or self-employed individuals. This article explores the various tax implications associated with interest income and capital gains from different types of bonds in India, helping readers make informed financial decisions.

Bonds represent a loan from investors to issuers such as governments or corporations, offering fixed returns over a defined period. In return, the issuer promises to pay regular interest (called coupon payments) and return the principal at maturity.

They are considered relatively safer than stocks and are often used for steady income and portfolio diversification.

Bonds are taxed in India based on two key factors — the type of bond and the period for which it is held. Both interest income and capital gains from bonds are subject to taxation under the Income Tax Act, making it important for investors to understand how their returns are taxed.

Interest Income on Bonds

The interest earned on bonds is generally added to the investor’s total income and taxed as per the applicable income tax slab rate.

• Taxable Bonds: Interest from most government or corporate bonds is fully taxable.
  

• Tax-Free Bonds: Interest is exempt under Section 10(15)(iv)(h) if issued by government-backed entities such as NHAI, REC, or PFC, commonly referred to as tax free government securities.
  

• TDS Rules: For resident investors, Tax Deducted at Source (TDS) is usually not applicable on listed bonds unless specified. For NRIs, TDS is deducted at 20% (plus surcharge and cess).
   

Capital Gains on Bonds

When bonds are sold before maturity, the profit or loss is treated as capital gains. The tax rate depends on whether the bond is listed or unlisted, and how long it was held.

• Listed Bonds in India:
  

  • Short-Term Capital Gains (STCG): If held for 12 months or less, taxed as per the investor’s income slab.
    

  • Long-Term Capital Gains (LTCG): If held for more than 12 months, taxed at 10% without indexation under Section 112.
    

• Unlisted Bonds:
  

  • STCG: If held for 36 months or less, taxed as per the income slab.
    

  • LTCG: If held for more than 36 months, taxed at 20% with indexation.

Understanding the taxation of bonds helps investors plan effectively, ensuring compliance while optimising post-tax returns.

There are various types of bonds available in India, each differing in issuer, risk, return, and taxation treatment. Below are some of the most common categories explained.

Government Bonds and Securities

Issued by the Central and State Governments, these are among the safest investments. Interest is taxable as per slab rate unless the bond is classified as a tax-free government security. Capital gains from listed government bonds are taxed at 10% without indexation.

Corporate Bonds

Issued by companies to raise capital, these bonds usually offer higher returns than government securities. Interest is fully taxable, while listed bonds taxation applies as 10% LTCG (without indexation) and slab-rate STCG.

Zero-Coupon Bonds

Sold at a discount and redeemed at face value, these bonds do not pay regular interest. The difference between the issue price and redemption value is treated as capital gains — 10% for listed and 20% with indexation for unlisted bonds.

Tax-Free Bonds

Issued by government-backed entities such as NHAI or PFC, the interest earned is exempt under Section 10(15)(iv)(h). However, capital gains on their sale are taxable based on the holding period.

Capital Gain Tax Bonds (Section 54EC)

Issued by NHAI, REC, or IRFC, these bonds offer exemption from capital gains tax if invested within six months of selling a long-term capital asset. The maximum exemption limit is ₹50 Lakh, and the bonds must be held for five years.

Inflation-Indexed Bonds

These government-issued bonds protect investors against inflation as both principal and interest adjust with inflation rates. Interest is taxable, and gains are treated as capital gains upon redemption.

Sovereign Gold Bonds (SGBs)

Backed by the Government of India, SGBs pay a fixed interest and mirror gold price movements. Interest is taxable, but long-term capital gains on redemption are exempt under current laws.

Municipal Bonds

Issued by urban local bodies to fund public infrastructure projects, these bonds may offer tax-exempt interest, depending on government notification. Capital gains are taxed based on holding period and bond classification.

Selling bonds before maturity can result in capital gains, and the tax treatment depends on whether the bond is listed or unlisted, the holding period, and the date of redemption.

• For bonds redeemed before 23rd July 2024:
  

  • Listed Bonds
    

    • Short-Term Capital Gains (STCG): If held for less than 12 months, gains are taxed as per the investor's income tax slab.
      

    • Long-Term Capital Gains (LTCG): If held for 12 months or more, gains are taxed at 10% without indexation.
      
      

  • Unlisted Bonds
    

    • STCG: Gains from bonds held for less than 36 months are taxed as per slab rates.
      

    • LTCG: Gains from bonds held for 36 months or more are taxed at 20% with indexation.
      

• For bonds redeemed on or after 23rd July 2024:
  

Both short-term and long-term capital gains on bonds are taxed as per the investor's applicable income tax slab rates, regardless of holding period or whether the bond is listed or unlisted. This is a significant change introduced by the Finance Act 2024.

Suppose an investor buys a listed bond for ₹1,00,000 and sells it for ₹1,10,000 after 14 months.

• If sold before 23rd July 2024, the ₹10,000 gain is considered LTCG and taxed at 10% without indexation.
  

• If sold on or after 23rd July 2024, the ₹10,000 gain will be added to the investor’s total income and taxed as per the applicable income tax slab.
  

Section 54EC of the Income Tax Act allows exemption on LTCG from sale of property if the proceeds are reinvested in specified bonds.

• Eligible bonds: REC, NHAI, PFC
  

• Maximum investment: ₹50 Lakhs per financial year
  

• Lock-in period: 5 years
  

• Interest: Taxable
  

• Exemption: On amount invested in 54EC bonds, subject to conditions
  

TDS, or Tax Deducted at Source, is applicable to interest earnings above a specified threshold.

• TDS applies if interest exceeds ₹5,000 in a financial year (threshold may vary based on government notifications and senior citizen status)
  

• TDS rate: 10% (with PAN); 20% (without PAN)
  

• No TDS on tax-free bonds
  

• For NRIs, TDS is applicable at a flat rate as per relevant tax treaties
  

1. For NRIs, bond taxation is governed by both the Income Tax Act and FEMA (Foreign Exchange Management Act).
   

   • Interest income: Taxed at a flat 20% plus surcharge and cess
     

   • TDS: Applicable at source; DTAA provisions may allow lower rates
     

   • Capital gains:
     

     • Listed bonds: LTCG @10%
       

     • Unlisted bonds: LTCG @20%
       

     • STCG: As per slab

Understanding how bonds are taxed helps investors anticipate their post-tax returns more accurately. By considering the type of bond, holding period, and applicable sections under the Income Tax Act, individuals can ensure tax compliance and effective portfolio management.

This content is for informational purposes only and the same should not be construed as investment advice. Bajaj Finserv Direct Limited shall not be liable or responsible for any investment decision that you may take based on this content.