How to generate monthly inflows from Tax-Free Bonds?

by Shiv Kukreja on September 23, 2013

in Uncategorized

This post is written by Shiv Kukreja, who is a Certified Financial Planner and runs a financial planning firm, Ojas Capital in Delhi/NCR. He can be reached at [email protected]

A couple of days back, I got an investor query on my email id asking me whether she should go for NCDs issue of India Infoline Finance Limited (IIFL) or not and can we expect any tax-free bonds issue to offer monthly interest option. She also told me that she falls in the 30% tax bracket and her mother, for whom also she wants to invest, falls in the 20% tax bracket.

So, if you have been reading my posts regularly, you must be knowing my thoughts about it by now. I told her that I think it is better to invest in HUDCO tax-free bonds as compared to IIFL NCDs as she and her mother both fall in the higher tax brackets and also it is always better to go with debt securities of the government-owned public sector companies vis-a-vis private sector issuers.

But, her reason for considering IIFL NCDs was different and genuine also. She wanted to have a regular monthly income for her mother and she was not able to take a decision between Post Office Monthly Income Scheme (POMIS), which is fetching 8.40% annually to its investors for FY 2013-14, and IIFL NCDs, which are going to give approximately 43% higher interest @ 12% per annum.

Though she knew that POMIS deposit is government backed and old age people should not take high risks with their principal investments by depositing their hard-earned lifetime savings with private companies, she wanted to earn higher rate of interest, interest rate which is able to earn them somewhat higher than the spiralling inflation.

I told her that the government has not allowed any of the companies to issue tax-free bonds with monthly interest payment option. The maximum these companies can offer is to make the interest payments twice in a year, on a semi-annual basis. But, no company till date has issued bonds with a semi-annual interest payment.

So, what is the deal? How can you generate regular monthly inflows from your tax-free bonds, which are designed to pay it only once every year, and pay tax only to the minimum extent possible?

By now, we all know the taxability rules of the bonds/NCDs listed on the stock exchanges. What did you say? You do not know the tax provisions as yet? Shame on me if you do not know the taxation rules even now, I have been writing these posts since ages now.

🙂 Just trying to make you people feel a little light and prepared for reading a long post!

As per the language of HUDCO tax-free bonds prospectus – “As per third proviso to Section 48 of Income tax act, 1961, benefits of indexation of cost of acquisition under second proviso of Section 48 of Income tax Act, 1961 is not available in case of bonds and debenture, except capital indexed bonds. Thus, long term capital gain tax can be considered at a rate of 10% on listed bonds without indexation”.

I hope at least now the taxation rules are clear! No ?? Still Not ?? What did you say ?? The language does not tell you the rules for the short term capital gain tax. Oh yes, I am sorry !! You are right, my mistake !!

So, here you have the taxation provisions with respect to the short-term capital gains – “Short-term capital gains on the transfer of listed bonds, where bonds are held for a period of not more than 12 months would be taxed at the normal rates of tax in accordance with and subject to the provision of the I.T. Act.

A 2% education cess and 1% secondary and higher education cess on the total income tax (including surcharge for corporate only) is payable by all categories of taxpayers”.

I hope now it is done and nobody will forget these rules now onwards!

So, you must be asking, am I suggesting you to start selling these bonds every month from the end of the first month itself from the date of their allotment ?? You are partially right. Yes, I am suggesting you to sell 1% of your investment in these bonds every month to get a sort of monthly income, but not from the end of the first month itself, but starting from the 13th month of your investment from tax planning point of view.

How it works?

Suppose, you fall in the higher tax bracket of 30% or 20% and invest Rs. 1 lakh in any of the tax-free bond issues, HUDCO, IIFCL, PFC, IRFC, NHB or any other company. Stay invested with these bonds for at least one complete year and from the thirteenth month onwards, you can start selling 1% of your investment every month. If you do that every month, you are going to get 1% of your investment i.e. approximately Rs. 1,000, for 100 months or 8 years & 4 months. This way it is going to last till 9 years and 4 months from the date of your investment and that is how it would be helpful if your investment is for 10 years.

Assumptions

* The investor takes tax-free bonds in a demat account, in order to sell them on a monthly basis or periodicity of his/her choice. It is very difficult to find a buyer for the physical bonds.

* After each annual interest payment, tax-free bonds are assumed to appreciate in value exactly equal to the monthly value of their annual interest. So, if the annual interest is 8.76%, then the market price of the bond is assumed to appreciate by 0.73% every month i.e. 8.76% / 12 months.

* Tax is paid as & when each monthly cash inflow is received.

* Brokerage charges on sale of the bonds have been ignored as they vary across different broking houses and across different investors. Investors should consider them before taking a final decision.

Let me try to explain you the monthly cash inflow table. Interest earned on IIFL NCDs is taxable as per the tax slab of the investor, so it has been termed as the “Normal Tax”, whereas long term capital gain tax on listed tax-free bonds is 10.30%.

IIFL NCDs post-tax monthly inflow = Interest Rs. 1,000 – Tax Rs. 309 @ 30.90% = Rs. 691.

IIFL NCDs post-tax monthly inflow = Interest Rs. 1,000 – Tax Rs. 206 @ 20.60% = Rs. 794

IIFL NCDs post-tax monthly inflow = Interest Rs. 1,000 – Tax Rs. 103 @ 10.30% = Rs. 897

HUDCO TFBs post-tax monthly inflow (Rs. 1,006.55 – for understanding purposes)

Sale Price of 1 Bond (13th month) = Rs. 1,000 * (1 + 8.76%/12) = Rs. 1,007.30

Long Term Capital Gain (LTCG) = Rs. 1,007.30 – Rs. 1,000 = Rs. 7.30

Long Term Capital Gain Tax = 10.30% of Rs. 7.30 = Rs. 0.7519

HUDCO TFBs post-tax monthly inflow = Rs. 1,007.30 – Rs. 0.7519 = Rs. 1,006.5481 (or Rs. 1,006.55)

If the investment is for 20 years or 15 years?

If your investment is for 20 years, you can either cut down your sale of these bonds by half or you can double your investment, in order to get the same monthly inflows for the next 16 years & 8 months, from next year onwards. You can do it with 15 years option also in a similar way. But, please mind it that to trade in these bonds, you are required to sell at least one bond. So, to have such monthly income for 15-20 years, you need to invest at least Rs. 1,50,000 to Rs. 2,00,000.

What about its annual interest?

I would call it a bonus. You can use it whichever way you want. You can reinvest it next year in any of the investment instruments you want. You can use it for meeting any of your other financial goals. You can go on a holiday with that money. You can use it along with your so called monthly income (sale of these bonds every month).

Basic idea behind it?

It is similar to a systematic withdrawal plan (SWP) of mutual funds. Though it must be clear to you by now, but I want to reiterate it here that the first basic idea behind this way out is to make tax-free bonds comparable to IIFL NCDs like instruments, which are giving 1% monthly interest to its investors throughout its holding period, but the interest is taxable as per the tax slabs of the investors.

The next basic purpose is to make your investment as tax efficient as it is possible. That is why I have suggested here to start selling these bonds from the next year onwards. You are required to pay only 10% tax on your long term capital gains you make by selling these bonds after one year.

If you really require regular inflows from the beginning itself, you can start selling these bonds from the beginning itself. The maximum you would be required to pay in tax in the first year would be exactly equal to the tax you are going to pay on the interest income earned from the IIFL NCDs.

Though I am still unaware of any major fallout of this technique of getting monthly inflows out of our tax-free bond investments, I am sure there must be some. I would like you people to do some brainstorming and find out at least one or two for me, so that we can try to work more on this idea and make it even better, if we can.

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