March 20, 2002

'15'

TAX TREATMENT OF DEEP DISCOUNT BONDS AND STRIPS

PRESS NOTE

    There have been certain reports in the press recently, suggesting that the tax treatment of deep discount bonds as specified in the Circular dated February 15, 2002 issued by the Central Board of Direct Taxes is anomalous, as it provides for taxation of income from such bonds on an annual basis, even though no income is received by the bond-holder before maturity. It has been opined that a heavy tax burden is being placed on persons who have been holding such bonds for a while, and a cumbersome obligation of valuing the bonds every year on the basis of RBI guidelines is being cast on small investors. The reports are mis-conceived and based on an incorrect understanding and inadequate knowledge of facts and law. The modified tax treatment now specified in fact corrects the anomalies in the existing system by providing a mechanism for taxing income accruing from year to year on deep discount bonds, on the same lines as income from normal coupon bearing bonds is taxed. Transfer of the bonds before maturity will attract capital gains tax, as in the existing system.

    The earlier system of taxing the entire income received from such bonds in the year of redemption as interest income was anomalous in that it gave rise to a sudden and huge tax liability in one year whereas the value of the bond had been progressively increasing over the period of holding. Further, where the bond was redeemed by a person other than the original subscriber, such person was taxed on the entire difference between the bid price and the redemption price as interest income. Such a system also created tax-induced distortions in the debt market, and was an impediment to the development of a market in STRIPS, which are essentially zero coupon instruments derived from normal coupon bearing bonds.

    Taxation of income on accrual basis is an established principle of law, and always results in taxing income that has not yet been received. Income from deep discount bonds accrues continuously over the period of holding and can be realized at any time by selling the bond. Taxing income from such bonds on accrual basis annually is, in fact, a practice followed world-wide.

    It is also an established principle that a circular issued by CBDT cannot have a retrospective tax effect. The present circular on deep discount bonds, therefore, specifies the tax treatment in respect of bonds which are issued after the issue of the circular, and does not seek to impose the modified treatment on existing bond-holders. Further, non-corporate persons who invest small amounts in new issues (face value upto Rs.1 lakh) can still opt for the old system.

    Valuing the bonds every year on the basis of RBI guidelines will not pose any problem as such values can be obtained from the issuers themselves, who will invariably be the RBI or a public financial institution.

    The amount received on redemption would always be liable to tax deduction at source as per normal provisions of the Income-tax Act. However, no TDS is required on interest payable on Government securities, and bonds issued by an institution, authority, public sector company or cooperative society can also be exempted from the requirement by notification.