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Subhash Lakhotia
Tax Treatment of Deep Discount Bonds

Presently there are a lot of anomalies existing in the Income-Tax law in respect of tax treatment of Deep Discount Bonds as well as Strips. The Central Board of Direct Taxes vide its Circular No.2/2002 dated 15.2.2002 has now clarified the thinking of the government in this regard. However, even though the present guidelines as contained in the above Circular are clear cut, but it would cause operational problems to the investors.
In any case the Circular issued by Central Board of Direct Taxes (CBDT) is binding both on the assessee as well as on the Department. Hence the contents of the Circular are discussed in the succeeding paragraphs. As per the above Circular it is provided that every person holding a Deep Discount Bond will make a market valuation of the bond as on the 31st March of each Financial Year (hereafter referred to as the valuation date) and mark such bond to such market value in accordance with the guidelines issued by Reserve Bank of India for valuation of investments. For this purpose, market values of different instruments declared by the Reserve Bank of India or by the Primary Dealers Association of India jointly with the Fixed Income Money Market and Derivatives Association of India may be referred to. The difference between the market valuations as on two successive valuation dates will represent the accretion to the value of the bond during the relevant financial year and will be taxable as interest income (where the bonds are held as investments) or business interest income (where the bonds are held as trading assets). If, however, the Deep Discount Bond is acquired during the year by an intermediate purchaser (a person who has acquired the bond by purchase during the term of the bond and not as original subscription) the difference between the market value as on the valuation date and the cost for which he acquired the bond, will be taxed as interest income or business income, as the case may be, and no capital gains will arise as there would be no transfer of the bond on the valuation date.
It is a well known fact that the Deep Discount Bonds can be transferred even before maturity. Where the bond is transferred at any time before the maturity date, the difference between the sale price and the cost of the bond will be taxable as capital gains in the hands of an investor or as business income in the hands of a trader. For computing such gains, the cost of the bond will be taken to be the aggregate of the cost for which the bond was acquired by the transferor and the income, if any, already offered to tax by such transferor upto the date of transfer.
The above Circular further clarifies that since the income chargeable in this case is only the accretion to the value of the bond over a specific period, for the purposes of computing capital gains, the period of holding in such cases will be reckoned from the date of purchase/subscription, or the last valuation date in respect of which the transferor has offered income to tax, the capital gains will be period would always be less than one year, view of this clarification it is very clear that in the event of Transfer of Deep Discount Bonds before maturity the benefit of long-term capital gains in the form of lower tax incidence is not available. However, in any case the benefit of Cost Inflation Index cannot be taken advantage of for Deep Discount Bonds. Hence, big investors in Deep Discount Bonds will be subjected to extra tax liability. The tax saving permissible to persons deriving long-term capital gains by making investments in specified bonds would now not be available to the investors of Deep Discount Bonds.
As regards the treatment to be given to Deep Discount Bonds at the time of redemption it is clarified in the above circular that where the bond is redeemed by the original subscriber, the difference between the redemption price and the value as on the last valuation date immediately preceding the maturity date will be taxed as interest income in the case of investors, or business income in the case of traders. If the intermediate purchaser i.e., the subsequent purchaser of the Deep Discount Bonds gets the Bond redeemed, then the difference between the redemption price and the cost of the bond to such purchaser will be taxable as interest or business income, as the case may be. For this purpose, again the cost of the bond will mean the aggregate of the cost at which the bonds were acquired and the income arising from the bond which has already been offered to tax by the person redeeming the bond.
The tax saving permissible to persons deriving long-term capital gains by making investments in specified bonds would now not be available to the investors of Deep Discount Bonds.

The above Circular also speaks about tax treatment in the case of stripping of the Bonds. Stripping means the process of detaching the interest coupons from a normal coupon bearing bond and treating the different coupons and the stripped bond as separate instruments or securities ('strips') capable of being traded in independently. The Central Board of Direct Taxes has further clarified that stripping would result into an instrument known as Deep Discount. Hence the tax treatment of the different components of principal and interest created by such stripping will be on the same lines as clarified in the preceding paragraphs in respect of Deep Discount Bonds. It is also clarified by the CBDT that the process of stripping of a normal interest-bearing bond into its various components will not amount to a transfer within the meaning of the Income-tax Act as it merely involves the conversion of the unstrained bond into the corresponding series of STRIPS. Similarly, the reconstitution of STRIPS to form a coupon-bearing bond will not amount to a transfer.
Coming to the aspects connected with Tax Deduction at source it is clarified by the CBDT that the difference between the bid price of a deep discount bond and its redemption price, which is actually paid at the time of maturity, will continue to be subject to tax deduction at source under section 193 of the Income-Tax Act. Under the existing provisions of that section, no tax is deductible at source on interest payable on government securities. Further the central government is empowered to specify any such bonds issued by an institution, authority, public sector company or cooperative society by way of notification, exempting them from the requirement of tax deduction at source.
Stripping means the process of detaching the interest coupons from a normal coupon bearing bond and treating the different coupons and the stripped bond as separate instruments or securities ('strips') capable of being traded in independently.

At the conclusion of the above circular the Central Board of Direct Taxes has given the option to investors that such investors holding deep Discount Bonds upto an aggregate face value of rupees one lakh may, at their option, continue to offer income for tax in accordance with the earlier clarifications issued by the Board. The earlier clarification and the thinking of the CBDT has also been enumerated in the above circular wherein the CBDT states that the Board had earlier clarified by way of certain letters issued to the Reserve Bank of India and others that the difference between the bid price (subscription price) and the redemption price (face value) of such bonds will be treated as interest income assessable under the Income-tax Act. On transfer of the bonds before maturity, the difference between the sale consideration and the cost of acquisition would be taxed as income from capital gains where the bonds were held as investment and as business income where the bonds were held as trading assets. On final redemption, however, no capital gains will arise. It was further clarified that tax would be deducted at source on the difference between the bid price and the redemption price at the time of maturity.
In view of the above Circular issued by the CBDT all investors must carefully work out their own incomes in respect of Deep Discount Bonds. However, only small investors holding Deep Discount Bonds of the face value of upto Rs. 1,00,000 can resort to the earlier clarification given by the CBDT. Very shortly the IDBI is going to redeem its Deep Discount Bond - Series 1 (1992). Hence the contents of the above Circular are of topical importance to the readers. In view of above clarification, the investment in Deep Discount Bonds would become less attractive as it would not at all be possible to derive Long-term capital gains on its sale before the redemption date.