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Tax-free bonds boon for retail investors
September, 22nd 2007
Two years ago, the tax department set in motion a policy aimed at restrictive access to tax-free bonds for investors with considerable capital gains from assets such as property.

For long, those with oodles of cash were able to take recourse to the window opened by the government for tax-free bonds.

For starters, the government pruned the list of eligible issuers of these bonds. Sometime last year, the revenue department decided to cap the amount an investor - be it an individual or a company - could park in capital gains bonds at Rs 50 lakh. An amendment was carried out this year to facilitate this later. Halfway into this fiscal, it is clear that the policy measures have worked well.

The state-owned Rural Electrification Corporation (REC), which has launched a tax-free bond issue, has seen the bonds being lapped up by individuals. No longer are large corporates interested in such a bond issuance given the cap. So, it is left to a few small and medium-sized firms to invest in such bonds. REC has so far raised close to Rs 1,375 crore from these bonds, popularly known as 54 EC bonds after the section in the Income-Tax Act.

Obviously, the policy measures have had their impact. The Rs 50-lakh cap on investment seems to be a deterrent for large companies.

Analysts say that these companies would rather pay capital gains tax and look at other avenues to invest the profits made on sale or transfer of real estate or other fixed assets. For the government, the huge retail participation is encouraging, as it will deter the biggies in the industry from using these bonds as a tax shelter.

Last fiscal, several retail investors had to sit out as these bonds were lapped up by the early birds. Three private sector companies together invested close to Rs 780 crore in the first tranche of REC bonds.

The government was keen on plugging this loophole and, hence, fixed a cap. At the same time, it kept subscription open to all investors, including individuals, companies, firms, among others.

REC raised close to Rs 8,000 crore from these bonds last fiscal. This fiscal, it has the leeway to raise any amount through this route as the government has not set an upper limit on the total size of this bond programme. Indications are that it may mop up half the amount - around Rs 4,000 crore. The corporation is offering an annual return of 5.5% on the capital gains bond, which has a three-year lock-in. Investors also have to pay tax on the interest income from these bonds.

Companies will not find these bonds attractive due to the three-year lock-in stipulation and the low coupon rate. Another disincentive is that these bonds cannot be used as collateral. The fixed return works out around 4.5-4.8%, which is minuscule. So big companies may opt to pay capital gains tax and look at other avenues to park these funds. But risk-averse retail investors may prefer to invest in these bonds, said Ernst & Young partner (global tax advisory services) Jayesh Sanghvi.

Besides REC, the National Highways Authority of India (NHAI) is also a government-approved issuer of capital gains bonds. Last fiscal, NHAI raised Rs 1,500 crore from these bonds. NHAI bonds are slated to hit the market next week.

Normally, if an individual or a trust sells immovable property or any other capital asset, the gains from such sale are taxed at 20%. However, if the gains are parked within six months from the date of transfer or sale in bonds offered by government approved issuers, the investor does not have to pay any capital gains tax.

While investors save on tax, the issuers of tax-free bonds - REC and NHAI - enjoy the comfort of a lower cost of borrowing. However, if the total money raised from these bonds taper, these institutions will have to look at alternative ways of raising resources to fund infrastructure projects.
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