Investors in the high tax brackets can use tax-free bonds to reduce their capital gains tax.

Interest stripping is a tax planning strategy that can help high networth individuals (HNIs) and investors in the high tax bracket to reduce their tax burden. It involves buying a bond just before the `record date' for interest payment (or income interest) and selling it after pocketing the interest.However, there will be some gap between the ex-interest date and the actual interest payment date. The market prices of all bonds include the accumulated interest till that date. In other words, the market price of bonds will fall after the record date and the quantum of fall will be equal to the interest received by you. This strategy, however, will not work with normal bonds because the interest is taxable and, therefore, it would negate the benefit of short-term capital losses you make using this strategy.

Interest stripping works well with tax-free bonds as short-term capital losses booked can be set off against other short-term capital gains. The time is ripe to use this strategy because the interest is due on several tax-free bonds (see table). However, you must be careful while executing this strategy . Says Mumbai-based tax expert Uday Ved: "Section 94 (7) of the Income Tax Act puts restrictions on such strategies." According to the section, the tax-free interest earned in the middle will be added back to the sales price before arriving at the capital gains in certain conditions. To avoid this, you have to buy the security three months before the record date. If you sell the bond after three months, the price would have fallen and the notional loss can be adjusted against certain other taxable capital gains.

The risks involved

Buying a bond for three months would mean you are taking a short-term gamble in the debt market. If the interest rates rise in the meantime, the price of the bond could come down, negating any gains from the tax arbitrage. You could, however reduce the risk by holding the bond for a longer period. This is because the probability of rates coming down is much higher compared to the rates going up in the next 12 months. Says Gajendra Kothari, Managing Director and CEO, Etica Wealth Management: "The 10-year yield is expected to come down by at least 50 basis points from current levels in the next one year." If you extend the holding period by over one year, you can get two tax-free interest payments.

Though it is an effective strategy, you need to take some precautions while implementing it. "Restrict yourself to bonds with enough liquidity ," says Raghvendra Nath, Managing Director, Ladderup Wealth Management. Buy bonds where the issue size is at least `500 crore to ensure higher liquidity.

How does the strategy work

To understand how the strategy works, let us consider the 8.3% tax-free bonds issued by Power Finance Corporation during 2011-12. The PFC bond was quoting at `1,085 on 20 September 2013, five days before its record date. Five days after the second interest payment in 2014 it was at `1,079. The interest payment date comes sometime after the record date.Since the buying price and selling price were almost equal, capital gains were made here. However, the investor receives two tax-free interests of 8.3% each (`83 each because interest is calculated on the face value of '1,000) during the period. This works out to be an absolute tax-free return of 15.37% for a holding period of 13 months. If the interest rates continue to fall over the next one year, as expected, other taxfree bonds should also generate similar returns. Even if we assume an annual gain of, say , 12%, investors could still benefit by way of getting two tax-free interest tranches and long-term capital losses that can be set off against other taxable capital gains.