How to Calculate Tax on Bonds as per the Income Tax Act?

Bonds are fixed-income investment instruments and they offer capital appreciation in the form of capital gains after maturity.

While a bond’s interest income is taxed at an individual’s slab rate, the capital gains are charged differently. Moreover, there are different types of bonds where some offer tax exemption while others are tax-free. Tax on bonds need to be calculated differently since bonds have debt and equity components attached to them. As an investor, you need to understand how to calculate tax on bonds before investing in bonds. 

This blog will explain the taxation of different bonds which includes the tax treatment of the interest income, and the gains received on redemption or sale of bonds in the secondary market. 

How Do Bonds Work?

Before we jump to the taxation of bonds, let us first understand the basics of how bonds work and the kind of income they offer. 

Bonds are debt instruments that provide fixed income in the form of interest. Such interest is paid either annually, semi-annually, or compounded and paid at maturity. However, zero-coupon bonds do not offer any interest. 

Once you have invested in bonds, either upon redeeming bonds at maturity or on selling them in the secondary market, you will have some profits made out of its buying and selling price, which is called a capital gain. Hence, bonds provide capital appreciation over a period. 

Also Read: Section 54: Guide on Section 54 of the Income Tax Act

Tax of Bond Incomes

To understand bond taxation, you need to first understand there are primarily two components that are taxed – interest and capital gains.

However, not all bonds offer interest, and that’s exactly why we will first understand the tax treatment of these two components and then discuss the taxation of different types of bonds.

1. Interest

Typically, bonds bear an interest rate required to be paid to bondholders at regular intervals depending on the type of bond you are investing your money in.

Such interest income is taxed at an individual’s slab rate. This interest income forms part of, ‘income from other sources’ income head of the return of income.

An important aspect of the interest income is that if the investor decides to receive a cumulative interest amount at the time of maturity, then it may impose colossal tax liability in the year of maturity to the investor. To avoid that, remember to accrue the interest annually even if it will be accumulated and paid after maturity.  

2. Capital Gain on Redemption

The bonds are issued at an issue price, and while redeeming the bond units or selling them in the secondary market, the current market value is considered (selling and redeeming bonds). Hence, there is a difference in the issue price and selling price, which is regarded as capital gain. 

Capital gain is reported under the income head of, ‘income from capital gains.’ However, the period of holding the bond decides whether the gain is long-term or short-term.

Generally, for listed bonds, any gain after 12 months is considered as a long-term capital gain. Whereas, for unlisted bonds, such period is 36 months, above which the gain is deemed to be long-term. 

Short-term capital gain is calculated at the slab rate depending on an individual’s income. Whereas, long-term capital gain is taxed at 10% without indexation or 20% with indexation, plus surcharge.

Also Read: All You Need to Know About Income from Other Sources

Bond types and How to Calculate Tax on Bonds?

There are different types of bonds in the market. Let us look at the types and taxation.

Regular Bonds 

Regular bonds comprise fixed rate bonds, floating rate bonds, convertible bonds, perpetual bonds, etc. The taxation of interest income earned from these bonds is done as per the applicable slab rates plus applicable surcharge and cess. Capital gains earned on redemption or sale in secondary markets will be subject to capital gains tax. 

In case of listed bonds, the holding period threshold is 12 months. If the holding period of such bonds is less than one year, all gains will be subject to short-term capital gains tax. The rate of short-term capital gains tax is as per the respective slab rates. 

On the other hand, if the holding period of such bonds is one year or more, all gains shall be taxable as per long-term capital gains tax. The rate of long-term capital gains tax is 10% without indexation. 

Now in case of unlisted bonds, the holding period threshold is 36 months. If you are holding such bonds for less than 36 months, short-term capital gains tax will be applicable on accrued gains. The taxation rate is similar to listed bonds. 

Whereas if the holding period is 36 months or more, all proceeds will be subject to taxation under long-term capital gains tax. The rate of long-term capital gains tax is 20% with indexation benefits. It is important to note that no TDS is applicable on the interest income of listed bonds. 

Zero-Coupon Bonds

Zero-coupon bondholders are liable to only capital gain tax as they do not provide any interest income. However, these are issued at a discount. Hence, the difference is taxed as capital gain. 

The capital gains taxation of zero coupon bonds is as follows: 

Market-Linked Bonds

Market-linked bonds offer fixed interest, and the interest rates are linked to the index it is tracking. Hence, interest is only paid if the bond’s interest rate is above the index performance level. 

Such interest is taxed under the slab rate, ‘Income from Other Sources,’ whereas any capital appreciation that arises is taxed as capital gain under, ‘Income from Capital Gains.’  

Government or Tax-Free Bonds

Government and Government-backed entities also issue bonds from time to time, the interest earned on which is tax-free. Hence they are also called tax-free bonds.

In other words, you do not need to pay tax on the interest earned. However, you will be charged a capital gain tax on the capital appreciation upon redemption or sale of these bonds. 

Certain government bonds such as sovereign gold bonds are exempted from capital gains tax if they are held until maturity.

Since most government bonds are listed, If the holding period is 12 months or more, long-term capital gains tax is applicable. However, if the holding period is less than 12 months, short-term capital gains tax will be levied. 

The STCG and LTCG tax rates are as follows: 

Section 54EC (Tax-Saving) Bonds

Section 54EC Bonds provide a long-term capital gain exemption from house property or land sale if such investment is made considering certain conditions. The interest income earned on these tax-saving bonds is taxable. 

However, you do not need to pay any long-term capital gain, upon maturity, as it is exempted from tax. Such bonds are required to be held for five years, and hence, capital gain tax is not charged on maturity.

Corporate Bonds

Companies issue corporate bonds to raise capital in their organisations. They offer considerably higher interest income, but corporate bonds can be secured or unsecured. Hence, there is a risk of losing your money entirely. 

The interest you earn from corporate bonds will be taxed as per your income tax slab under the head ‘Income from Other Sources’. The selling price and the holding period of the bond determine capital gains from bonds.

The tax treatment of capital gain from bonds depends on the holding period and the type of bond. Listed bonds are considered long-term after 12 months, while unlisted bonds are considered long-term after 36 months. Short-term gains for both listed and unlisted bonds are taxed at the individual slab rate. Long-term gains for listed bonds are taxed at 10% without indexation, while long-term gains for unlisted bonds are taxed at 20%.

A holding period of 12 months or more is considered long-term for listed bonds, while for unlisted bonds, it’s 36 months. Short-term gains for listed and unlisted bonds are taxed at the individual slab rate. Long-term gains are taxed 10% without indexation for listed bonds and 20% for unlisted bonds.

Also Read: Long-Term Capital Gains Tax Exemption – List of Exemptions as per IT Act

The Bottom Line

The taxation of various investment instruments, primarily bonds, and debentures, is a bit tricky. Since they have debt and equity elements in their investment, their tax should be understood well before making any investment decision.

We always recommend consulting your financial consultant before investing in such bonds to clarify the amount of  tax you will pay and the net returns you can make out of it. 

Happy Winting!

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