NCDs: Tax Benefits and Issues

Debentures are medium to long-term debt instruments which are are used by large companies to borrow money at a fixed rate of interest. Unlike Shareholders, Debenture holders have no rights to vote in the company’s general meetings of shareholders. However in general like shares, debentures are freely transferable. Debentures can be Secured or unsecured Debentures. Secured NCDs are backed by the issuer company’s assets to fulfill the debt obligation in contrast to unsecured NCDs. Further there are Convertible debentures, that can be converted into equity shares of the issuing company after a predetermined period . These debentures are not much in vogue these days. The common type is Non-convertible debentures which carry fixed interest for medium to long term tenure which can be payable monthly/half yearly/annually/ on maturity or a combination thereof. NCDs cannot be converted into equity shares of the issuing company.
Non Convertible Debentures i.e. NCDs are considered to be one of the good debt options for the purpose of investments as they offer attractive rate compared to other fixed income investment channels. It was felt that there is some lack of clarity on how to calculate Tax on NCDs. This post will try to throw some light on Iues related to Tax on NCDs.

1) TDS (Tax Deduction at Source)
NCDs are not subjected to TDS provided they fulfill certain conditions. With respect to TDS, as per section 193 of the Income Tax Act, no , no income tax is deductible at source on any security issued by a company in a dematerialized form and is listed on recognized stock exchange in India in accordance with the Securities Contracts (Regulation) Act, 1956 and the rules made there under (with effect from June 1, 2008).

However, TDS is applicable to NCDs if they are in physical form. Also, a Non Resident Indian (NRI) who invests in NCDs is subject to TDS according to section 195 of the IT act. This suffices our purpose and we shall not dwell on other circumstances in which TDS exemption is available on NCDs.

2) Tax on NCDs:

2.1 Definition of Short Term / Long Term Capital Asset

Capital asset held for not more than 36 months immediately prior to the date of transfer shall be deemed as short-term capital asset. However, following assets held for not more than 12 months shall be treated as short-term capital assets:

a) Equity or preference shares in a company which are listed in any recognized stock exchange in India;

b) Other listed securities;

c) Units of UTI;

d) Units of equity oriented funds; or

e) Zero Coupon Bonds.

As per Section 2(29A) of the I.T. Act, read along with Section 2 (42A) of the I.T. Act, a listed debenture is treated as a long-term capital asset if the same is held for more than 12 months immediately preceding the date of its transfer.

2.2 NCDs: Tax on Long Term Capital Gains (i.e. Tax on NCDs held for more than a year)

Under Section 112 of the I.T. Act, capital gains arising on the transfer of long term capital assets being listed securities are subject to tax at the rate of 20% of capital gains calculated after reducing indexed cost of acquisition or 10% of capital gains without indexation of the cost of acquisition. The capital gains is computed by deducting expenditure incurred in connection with such transfer and cost of acquisition / indexed cost of acquisition of the debentures from the sale consideration.

Further in the case of long-term capital gain which arises on transfer of debt oriented mutual fund units, the above concessional rate of 10 percent will not be available if the transfer takes place after 10th July 2014. Thus only the rate of 20% with indexation is to used when computing Long term gains from debt oriented mutual funds.(Not related to our present topic)

Coming specifically to NCDs, as per the third proviso to Section 48 of I.T. Act, benefit of indexation of cost of acquisition under second proviso of Section 48 of I.T. Act, is not available in case of bonds and debenture, except capital indexed bonds and Sovereign Gold Bonds. (Click to see Section 48). Thus long term capital gains arising out of listed debentures would be subject to tax at the rate of 10% computed without indexation.

In case of an individual or HUF, being a resident, where the total income as reduced by such long-term capital gains is below the maximum amount which is not chargeable to income-tax, then, such long-term capital gains shall be reduced by the amount by which the total income as so reduced falls short of the maximum amount which is not chargeable to income-tax and the tax on the balance of such long-term capital gains shall be computed at the rate mentioned above.

2.3) NCDs: Short-term capital gains on the transfer of listed NCDs

If debentures are held for a period of not more than 12 months, they would be taxed at the normal rates of tax in accordance with and subject to the provisions of the I.T. Act. The provisions relating to maximum amount not chargeable to tax described at 2.2 above would also apply to such short-term capital gains.

Standard disclaimer: I am not a SEBI registered analyst or a Tax consultant. The above article is purely from the angle of my academic interest to bring more clarity in this matter. Iam not to be held responsible for any inaccuracies in this article and any decisions on tax need consultation with qualified tax consultants.