How is tax on NCDs calculated?

by Manshu on August 30, 2011

in Tax

Reader Kanti Kiran emailed me with a couple of corrections related to taxation of NCDs post that I wrote yesterday, and I’m going to talk about them in this post.

I said that the cumulative NCD option is not tax free, and that the money you get during the redemption will attract capital gains.

Kanti Kiran wrote to me saying this isn’t correct, and while the amount is taxable, it’s not taxable as capital gains, but as interest income that will be clubbed with your other income and taxed at your regular tax rate.

This is a meaningful difference because people at the highest tax rate will have to pay about 30% tax on this income instead of the lower capital gains tax rate.

There was another reader who weighed in on the subject, and he opined that if there is a coupon rate associated with the NCD, and if that NCD pays out a cumulative option then you have to declare the income every year, and pay tax on that much like the tax on recurring deposits.

However, if there is no coupon rate on the NCD and they pay a lump-sum amount then that will be treated as capital gains. It’s not quite clear to me how a coupon rate gets associated to a cumulative NCD.

I couldn’t find an authoritative source on any of this, so if any of you have practical experience or know for sure how this income should be treated then please leave a comment or email me.

There was also a comment on treating capital gains on these NCDs in the same way that you would treat the capital gains on shares if you buy or sell the NCDs on the stock exchange.

The rationale for treating them as equity funds is that you pay Securities Transaction Tax (STT) on these transactions. I checked with Shiv on the transactions that he has done on the exchange, and he hadn’t paid any STT on the NCD he sold, so it doesn’t look like you can treat capital gains on NCDs in the same way as equities.

The last point was about no TDS on only those NCDs that are listed and are compulsorily in Demat form. You will remember that this is what we talked about when infrastructure bonds were issued last year when many of them were first compulsorily Demat and then turned into physical form, and a bit of confusion ensued.

Since one of the main features of these NCDs is listing in an exchange, and they are seeing a lot of demand from people who have Demat accounts – I don’t see them changing this aspect of the NCD, but it’s a good point to keep in mind.

So, these are the various interpretations of the tax on NCDs that have been shared so far, and I will appreciate any feedback that you may have on this.

Thanks to Kanti Kiran, ankm83 and Shiv for weighing in and giving input for this post, and I apologize to everyone for not getting this right on the first go.

{ 16 comments… read them below or add one }

ankm83 August 30, 2011 at 9:19 am

Hi manshu, its an interesting post. it would be good idea to get clarity from some tax/investment expert on the taxability aspect. My personal experience & knowledge is what i shared with you on the other post.

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ankm83 August 30, 2011 at 9:51 am

Similar to manappuram 400 day, the IIISL ncd option II (40 month) also has no coupon associated with it. In fact, it seems true (as per financial websites/newspapers) these NCDs will attract CG tax. I think listed NCDs which do not have periodic interest payment & which pay upon maturity, will be subject to capital gains tax. Unlisted/Privately placed Cumulative NCDs will attract annual tax. On the other post, i mentioned about privately placed cumulative NCDs of STFCL interest on which is subject to tax every year. Comments from experts are welcome!!!

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ankm83 August 30, 2011 at 10:05 am

Besides the tax efficiency aspect, cumulative/Zero coupon NCDs do not have reinvestment risk (fixed IRR/YTM). In a NCD paying out interest annually, the latter has to be reinvested at lower rates, in a future scenario of fall in interest rates (so IRR/YTM falls below coupon). But perceived fundamental default risk is higher, since all the cash flows are concentrated and farther from today, this possibly explains the discount which IIISL cumulative NCDs (40 month) have to 36 month payout NCD.

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Manshu August 31, 2011 at 4:45 am

I have sent a note out to a couple of my CA friends to get some feedback from them, and will update this post when I get something solid. Thanks for your inputs Ankm83.

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Paresh September 3, 2011 at 5:42 pm

My opinion is that interest from NCDs is added in income of investors.
One can show the income annually as well cumulatively at the end of period.
I have invested in Tata Capital NCDs (in 2009)as well as in fixed deposits of tata motors back 2-3 yrs.Tata capital have not provided interest flow for NCds so i will pay the taxes at time of its maturity.while tata motors have provided interest flow statement and i can calculate total interest received from it so i show it annually.
Remaining for,, fixed deposits/Rds we can get interest paid certificate from banks and same can be shown annually also.

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akash December 27, 2011 at 4:12 pm

I have purchased tata capital NCD from secondary market in the september month by paying a premium amount of around 100 rupees. Now when i receive the interest in the month of march say around 120 rupess, how much income i should show in my books as the interest income ? Whether it should be 120 rupees or just 20 Rs. or 120-6 months accrued interest upto septtember.

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Manshu December 29, 2011 at 12:12 am

I don’t know about that Akash.

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sGemini January 2, 2012 at 1:31 pm

Interest earned through NCDs, if held until maturity, is clubbed with your income and taxed at your marginal income tax rate. If you sell your NCDs on the stock exchange before a year then you will have to pay short-term capital gains at income-tax rates applicable to you. If the debenture is encashed after one year but before its maturity, you will have to pay capital gains tax on the effective return.

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Ram Mohan January 12, 2012 at 1:13 pm

Interesting blog. I also have Tata Cap NCDs both from the initial issue as well as bought through secondary market and held in Dmat form. Based on the comments received so far, two things emerge:
1) if NCDs are held till maturity, the entire appreciation is added to the taxable income and taxed at marginal interest rate
2) if NCDs are sold off prior to maturity then LTCG is payable (if held for more than 1 year)
If the above is true, wouldn’t everyone try to sell off their holdings in the secondary market just prior to maturity to qualify for the lower LTCG?
Is there a loophole here somewhere?
Comments are welcome

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Manshu January 12, 2012 at 9:35 pm

Since the price on the secondary market depends on the interest payments, I don’t see a situation where a bond is close to its maturity and still trading at a big premium. The premium will adjust lower with every interest payment, and if it’s too close to the maturity then there may be none left.

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Ram Mohan January 13, 2012 at 11:07 am

Dear Manshu,
This may be true for a periodic interest bearing bond. How about a cumulative bond such as series 4 NCD of Tata cap. If one were to sell the bond close to maturity in the market, he gets away with LTCG, whereas if one holds till maturity he ends up paying marginal tax on the total appreciation. I am sure this is not how it is meant to be. There must be a catch somewhere.
Comments are welcome as always

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Manshu January 14, 2012 at 9:47 pm

Oops I’m sorry I didn’t think of that when I wrote the earlier comment. Sorry about that!

Frankly, this situation hadn’t occurred to me before you left the comment. I’ll try to find out from some other people who might know and will leave a comment here if I find out something.

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Ram Mohan January 16, 2012 at 12:15 pm

Dear Manshu,
It will be great if we can find out the right tax treatment on NCDs. I have also been researching on this, but could not find a categorical answer. One more pertinent aspect to consider would be that since the market always finds the right price, a study of the quotes of these NCDs could provide an answer. For instance, if the hypothesis is that the NCDs attract LTCG if they are sold in the market before maturity, the market rates should come down just before maturity and the yields could go up.

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Manshu January 16, 2012 at 9:40 pm

I did reach out to a few CAs a few months ago, and I can do that again. I don’t think you can rely too much on the market for NCDs right now because it’s not deep enough and you already see some of unusual pricing in there esp with the inability of people to short bonds.

Let me take a relook at this.

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Savio June 2, 2012 at 7:08 pm

Guys, I am attaching the link of Edelweiss that gives you the answer. Just in case the site goes down, I am also copy-pasting the answer here:

What are income tax implications? How the returns from NCDs are taxed?

There can be two types of income from NCDs:

First is the interest income from a NCD and tax treatment is exactly similar to any other interest income such as interest income from FDs. In other words, interest income from NCDs will be subjected to tax at normal rates by including it in ‘Income from other sources’.

Next is capital gains. If you decide to sell the NCDs on the stock exchange, capital gains can also arise. If NCDs are sold within a period of 12 months from the date of allotment, short term capital gains / loss (STCG) will arise and if you decide to sell NCDs after a period of 12 months, the resulting gain or loss is called long term capital gains / loss (LTCG).

While short term capital gains on sale of NCDs would be taxed at normal rates, long term capital gains on sale of NCD (a listed security) are taxed at concessional rates u/s 112 of IT Act.

Long term capital gains on listed securities are taxed at the rate of 10% without indexation or 20% with indexation whichever is lower. However, as the benefit of cost indexation is not available in case of bonds and debentures; therefore, long term capital gains from NCDs are always taxable @ 10.30 per cent (including education cess of 3%) without indexation.

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Neeraj September 28, 2012 at 9:13 am

Capital gains is applicable ONLY when there is a transfer of capital assets.

Maturity of an NCD is not a transfer of capital asset and irrespective of the interest frequency, the income thus received is clubbed with total income of the recipient.

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