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Taxes deflate inflation bonds
December, 20th 2013

The Reserve Bank of India (RBI) announced the launch of Inflation Indexed National Savings Securities–Cumulative (IINSS-C) bonds, which would be sold through banks to retail investors. As RBI clarified, these securities will be launched in the backdrop of an announcement made in the Union Budget 2013-14 to introduce instruments that will protect savings from inflation. Now, the main clue to whether these securities meet their objective lies in the way the income from these bonds will be taxed. Basically, the interest rate on the securities is linked to the consumer inflation rate, and consists of two parts: one is fixed at 1.5%, and the other is the inflation rate based on the Consumer Price Index (CPI). Effectively, the interest will be 1.5% above the consumer inflation rate. The central bank’s press release clarifies that tax treatment on interest and principal repayment would be according to the extant taxation provision.
Tax treatment

The interest on the bonds, consisting of both the fixed component of 1.5% as well as the variable component of the inflation rate, would clearly be taxable as interest income under the head “Income from Other Sources”, and not as capital gains, even though the entire amount is received on maturity. The accumulated interest would be taxable each year, unless the investor chooses to account for such interest on a receipt basis, in which case, the entire interest would be taxable in the year of maturity when the interest is received. In either case, it would be subject to the income tax slab rate applicable to the investor.

Here’s an example. If the inflation rate is 10% and the interest income is Rs.575 on Rs.5,000 (the face value), an investor falling in the 30% tax bracket would pay tax of Rs.177.68 (30.90%). So, the net interest income for her becomes Rs.397.32. This amount is 7.94% of the invested amount; a rate below the inflation rate of 10%. Would this lower rate of interest be compensated by a capital loss on redemption of the security? Normally, for computation of capital gains, the cost of acquisition of an asset can be indexed based on the Cost Inflation Index notified by the Central Board of Direct Taxes (CBDT). This index is increased by 75% of the average rise in the CPI for urban non-manual employees in the immediate preceding year. Therefore, it neutralises only 75% of the inflation effect.

However, the benefit of indexation of cost of acquisition is not available to bonds or debentures other than capital-indexed bonds issued by the government. So, can the inflation-indexed bonds be regarded as capital-indexed bonds issued by the government? The term has not been defined in the Income Tax Act. However, in December 1997, Capital Indexed Bonds, 2002, were issued wherein only the principal repayments at the time of redemption were indexed to inflation. These were linked to the Wholesale Price Index. So, it appears that these capital-indexed bonds to do not include the recently introduced IINSS-C securities. This means that no indexation of cost of acquisition would be available for computing capital gains on redemption. Since the original amount would be refunded on maturity at the face value, which is also the cost of acquisition, there would be no capital gain or loss on maturity.

In effect this means that the post-tax rate of return on such securities would be below the rate of inflation, and would not serve the purpose of having such securities.
Tax on interest

Would tax deducted at source (TDS) apply to the interest, and if so, when would it be deducted? Yes, TDS will apply as these securities are unlisted and issued by the government (so, these will be held in the bond ledger account and not the demat account). The TDS exemption on interest that is available on listed securities issued by a company held in demat form would not be available. But there is an exemption for interest payable on any security issued by the central or a state government. It has been clarified that all the provisions of the Government Securities Act, 2006, apply to these securities. So, there would be no TDS on such interest.

All in all, the tax department takes back a part of the benefits that the government planned to give. One hand of the government gives, and the other hand takes back a part of it. This defeats the very purpose of providing relief from inflation. Inflation affects personal expenses, which are met after taxes have been paid. The net increase in income has to be higher than the inflation rate for the bonds to really protect savings. One wishes that either the fixed rate was high enough to take care of the taxes, or the interest was tax-free. Then the securities would really have neutralised inflation. Perhaps, that is too much to hope for from a government facing an increasing fiscal deficit!

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