Let’s take an example to have a more clear understanding:

Assume Mr. A invests Rs.10,00,000 in bonds that offer a 10% coupon rate payable annually. At the end of year 1, Mr. A will receive Rs.1,00,000 as interest. Suppose Mr. A’s total income is Rs. 8,00,000, which places him in the 20% tax slab as per the old tax regime. Therefore Mr. A will be liable to pay tax on Rs.1,00,000 at the rate of 20% under the “IFOS” head.

If you purchase or sell bonds in the secondary market, it is important to understand the taxation implications of accrued interest. The Interest earned on bonds bought in the secondary market is taxed on an accrual basis rather than a receipt basis.

For instance, if a bond is sold with accrued interest of Rs. 9,000 and the buyer receives Rs.12,000 in interest at the end of the year, the seller will be liable to pay tax on the accrued interest of Rs.9,000. This amount will be added to the seller’s total income rather than the buyer’s. To simplify, investors must pay taxes on the interest earned during their holding period rather than the total interest received.

Interest income earned from Bonds and Debentures is also subject to tax deduction at source. Previously, the securities held in dematerialised form and listed on recognised stock exchanges in India were exempt from TDS. However, this has been omitted in the recent Budget for FY 2023-24.

According to Section 193 of the Income Tax Act, 1961, all interest income from securities will be subject to Tax Deducted at source (TDS). Effective from April 01, 2023 TDS at the rate of 10% will be deducted from the interest income of all listed as well as unlisted Bonds. This implies that interest earned on all Bonds will now be subject to TDS.

Uncovering Capital Gain - Tax on Bond Investments Made in the Secondary Market

When an investor sells the Bond in the secondary market, it results in a capital gain/ loss. The Capital Gain is calculated as the difference between the Sale consideration and the Cost of the asset. For instance, if an investor sells the bond in the market at a lower price than the acquisition cost, it results in a capital loss. Conversely, if the investor sells the bond at a higher price than the acquisition cost, it leads to a capital gain.

The Capital Gain tax is determined on the basis of the period of holding the bond. Period of holding refers to the time period for which the investor holds the asset i.e. duration for which the investor holds the bonds. In the case of listed bonds i.e. bonds that are listed on a recognized stock exchange, if the period of holding is equal to or less than 12 months then the investor will be subject to short-term capital gains tax on the profits at their respective slab rates. If the holding period exceeds 12 months then it will be classified as long-term capital gains tax, which would be levied at a rate of 10% without indexation.

If the bonds are unlisted, meaning they are not listed on recognized stock exchanges, the short-term gain tax will apply if the period of holding is less than or equal to 36 months. These gains will be taxed at an individual slab rate. However, if the holding period is more than 36 months, the long-term capital gain tax will be applicable and it would be taxed at 20% without indexation under the Long Term Capital Gain head. The following table provides a clear understanding of taxation:

However, it is pertinent to note that the Capital indexed bonds and Sovereign Gold bonds qualify for the indexation benefits. The tax rates mentioned above apply to all regular bonds but certain bonds have unique tax treatment. The same is highlighted in the table below: