TAXATION OF DEBT PRODUCTS

TAXATION OF DEBT PRODUCTS (Part 1)

• Definition: Debt instruments are used by entities to raise funds from the market, similar to giving a loan to the issuing entity by the investor.
• Details: The person holding the debt instrument of an entity would not hold any voting power or dividend claim, but is entitled to receive interest and redemption value at the time of maturity from the entity.

Key Concepts

• Sources of Income from Debt Products: Periodic income earned from debt instruments is classified as interest income, while gain or loss arising from transfer or redemption of debt instruments is classified as capital gains and taxed as such.
• Interest Income: Taxable under the head ‘income from other sources’ if not taxable under the head business income, and computed in accordance with the method of accounting regularly employed by the assessee (mercantile system or cash system).
• Capital Gains: Gain or loss arising from transfer or redemption of debt securities is chargeable to tax under the head capital gain if held as a capital asset, with tax depending on factors such as nature of security, period of holding, and residential status of the assessee.

Types of Debt Products

• Coupon Bonds: Bonds that carry a coupon rate, entitling the lender to periodic interest payments, with the market value determined by computing the present value of all future cash flows.
• Tax on Interest from Bonds: Generally taxable under the head other sources at a normal rate, with the assessee allowed to deduct expenditures laid out to earn such interest income.

Tax on Capital Gains from Bonds

• Long-term Capital Gain: Taxable at a rate of 12.5% for listed bonds held for more than 12 months, with no benefit of indexation, and computed as the difference between the full value of consideration and the cost of acquisition.
• Short-term Capital Gain: Generally taxable at normal rates as applicable in case of an assessee, with capital gains from unlisted bonds or debentures always taxed as short-term capital gains.
• Tax on Long-term Capital Gain for Non-Resident Indians (NRIs): Taxable at a rate of 12.5% for listed bonds, with no benefit of indexation, and computed as the difference between the full value of consideration and the cost of acquisition.

Taxation of Debt Products (Part 2)

• Capital Gains: Irrespective of the holding period, capital gains are chargeable to tax.
• Interest Income: The interest received from debt products is taxable as per the applicable tax rate.

Example: Computation of Interest and Capital Gain

• Interest Income: Computed as the difference between the face value and the issue price, or as the interest received.
• Capital Gain: Computed as the difference between the sales consideration and the cost of acquisition.

Government Securities

• Definition: Government Securities (G-Secs) are tradable instruments issued by the Central Government or State Governments.
• Types:
  • Cash Management Bills: Issued for a short period, usually less than 91 days.
  • Treasury Bills: Short-term debt instruments issued at a discounted price, with a maturity period not exceeding 1 year.
  • Dated Government Securities: Bonds issued by the RBI on behalf of the government, carrying a fixed or floating coupon.
  • State Development Loans: Loans raised by State Governments, with interest serviced at half-yearly intervals.

Taxability of Government Securities

• Cash Management Bills and T-Bills: The income is the difference between the issue price and the face value, and is considered as a short-term capital gain.
• Dated G-Secs and SDLs: The taxability is the same as for listed bonds, with no tax deduction required for interest payments to resident persons, except for certain bonds.

Tax-Free Bonds

• Definition: Bonds that provide tax-free income, with the interest paid being tax-free in the hands of the investor.
• Tax Implications: The interest is exempt under section 10 of the Income Tax Act, but capital gains arising on transfer or redemption are chargeable to tax.

Mutual Funds

• Definition: Funds that collect money from investors and invest in the capital market.
• Types:
  • Equity Oriented Funds: Invest in shares of companies.
  • Debt Oriented Funds: Invest in debt securities or interest-bearing instruments.
  • Money Market Funds: Invest in liquid instruments like Treasury Bills and Commercial Papers.
  • Balanced or Hybrid Funds: Invest in a mix of assets, including equity, debt, and money market instruments.
• Tax on Income: Mutual Funds offer two main sources of earnings: Capital Gains and Dividends, which are taxable as per the applicable tax rate.

TAXATION OF DEBT PRODUCTS (Part 3)

• Introduction to Taxation of Debt Products: The taxation of dividend incomes from different types of mutual funds is governed by common provisions under the Income Tax Act. However, the taxation of capital gains resulting from the transfer or redemption of mutual fund units depends on the type of fund.
• Classification of Mutual Funds for Taxation Purposes: Mutual funds are now classified into four types for taxation purposes:
  • Equity-oriented Mutual Funds
  • Specified Mutual Funds (that invest 65% or more of the proceeds in debt or money market instruments, directly or indirectly, and are bought after April 1, 2023)
  • Specified Mutual Funds (mutual funds other than mentioned in 2 above, which invested less than 35% of the proceeds in equity shares of Indian companies directly and were bought after April 1, 2023 but sold before April 1, 2025)
  • All Other Mutual Funds

Tax on Dividend from Mutual Funds

• Taxability of Dividend Income: Dividend received by a resident unit-holder from a mutual fund shall be taxable in his hands as per applicable tax rates.
• Deduction of Interest Expenditure: An investor is allowed to claim a deduction of interest expenditure incurred to earn that dividend income to the extent of 20% of the total dividend income.
• Taxation of Dividend Income for Non-Resident: Where the dividend is received by a non-resident person, the dividend shall be taxable at 20% (subject to the provisions of the DTAA).

Tax on Capital Gain from Specified Mutual Funds

• Taxation of Capital Gains from Specified Mutual Funds: The capital gains arising from the transfer, redemption or maturity of such SMFs shall be taxable as short-term capital gains irrespective of the period of holding.
• Computation of Short-term Capital Gains: The short-term capital gains from SMFs shall be computed by deducting the cost of acquisition and expenditure incurred wholly and exclusively in connection with the transfer or redemption of SMFs from the full value of consideration.
• Taxation of Capital Gains from Other Specified Mutual Funds: The taxation of capital gain from this limited edition Specified Mutual Fund is governed by the provisions of Section 50AA and is same as the previous type, i.e. all gains are taxed as short-term capital gains at applicable rates.

Tax on Capital Gains from Other Mutual Funds

• Long-term Capital Gain: Long-term capital gain arising from the transfer of such funds is chargeable to tax at the rate of 12.50%.
• Short-term Capital Gain: Short-term capital gains arising from the sale of units of such mutual funds is chargeable to tax as per the rate applicable in case of an assessee.
• Computation of Capital Gain: The difference between the value at which an investor purchased the units of a mutual fund scheme and the value at which these units are sold or redeemed shall be taxable under the head capital gains.

Taxation of Non-Residents

• Double Taxation Avoidance Agreements (DTAAs): Non-residents are generally exposed to double taxation due to tax liability in two or more countries. To avoid this, countries have entered into DTAAs with other countries.
• Tax Residency Certificate (TRC): To claim any relief under the DTAAs, the non-resident will be required to obtain a Tax Residency Certificate (TRC) of the country of its residence.
• Concessional Tax Rates: Non-resident individuals who are Indian citizens or Persons of Indian Origin have an option to avail the provisions of chapter XII-A of the Income Tax Act which provide concessional rate of tax.

TAXATION OF DEBT PRODUCTS (Part 4)

• Exemption of Long-term Capital Gains: If an individual re-invests the net consideration from the sale of an asset within six months in the same or other specified assets, the long-term capital gains can be claimed as exempt.
  • Full Re-investment: If the entire net consideration is re-invested, the whole of the long-term capital gains is exempt.
  • Partial Re-investment: If only a part of the net consideration is re-invested, the proportionate amount of long-term capital gains will be exempted.
• Taxation on Transfer of New Asset: If the new asset is transferred within three years from the date of acquisition, the capital gains that were earlier claimed as exempt will be taxed in the year of transfer.
• Option to be Taxed at 20%: The assessee can opt to be taxed at 20% on investment income related to debentures and deposits in non-private companies and government securities, even after becoming a resident in India.
• Non-Resident Taxation: As long as the individual remains a non-resident, they can choose not to be governed by the provisions of this chapter.

Taxation of Overseas Retirement Funds

• Finance Act 2021: Introduced amendments to address the mismatch in taxation of income from notified overseas retirement funds.
• Section 89A: Provides that the income of a specified person from a specified account shall be taxed in the manner and in the year prescribed by the Central Government.
• Specified Person: Defined as a person resident in India who opened a specified account in a notified country while being non-resident in India and resident in that country.
• Specified Account: Defined as an account maintained in a notified country for retirement benefits, where the income is not taxable on an accrual basis and is taxed at the time of withdrawal or redemption.
• Notified Countries: Currently include the United States of America, Canada, and the United Kingdom.

Taxation of Market Linked Debentures (MLDs)

• Definition: MLDs are financial instruments with returns linked to the performance of an underlying market index or security.
• Types of MLDs:
  • Principal Protected MLDs: Guarantee the return of the investor's principal amount at maturity.
  • Principal Non-Protected MLDs: Do not guarantee the return of the principal amount at maturity.
• Taxation:
  • Section 50AA: Governs the taxability of income arising from MLDs held as capital assets.
  • Short-term Capital Gains: MLDs transferred, redeemed, or matured on or after April 1, 2023, shall be subject to taxation under Section 50AA, regardless of the period of holding.
  • Computation of Short-term Capital Gains: Shall be computed by deducting the cost of acquisition and expenditure incurred from the full value of consideration.

Benefits Not Allowed from Capital Gain Arising from MLDs

• No Benefit of Period of Holding: Capital gains from MLDs shall be taxable as short-term capital gains, irrespective of the period of holding.
• No Deduction for Cost of Improvement: The cost of improvement shall be taken to be nil, notwithstanding whether it has been incurred by the assessee or the previous owner.

Summary of Taxation of Debt Products

• Tax Rates: Vary depending on the type of debt product, period of holding, and residency status of the investor.
• Products: Include sovereign gold bonds, listed and unlisted bonds, treasury bills, dated government securities, municipal debt securities, debentures, and specified mutual funds.
• Notes:
  • Note 1: Capital gain arising from the redemption of sovereign gold bonds is not chargeable to tax.
  • Note 2: A resident shareholder is allowed a deduction of interest expenditure incurred to earn dividend income from specified or debt-oriented mutual funds.
  • Note 3: Specified mutual funds are categorized into Type 1 and Type 2 based on their investment patterns.