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New tax-free bonds may click with individual investors, not banks
September, 16th 2015

Tax-free bonds (TFBs) are issued with a view to attract investors who have an appetite for long-term investments with tax exemption benefits. Though the interest earned on these bonds is tax-free, any capital gain from the sale of these bonds in the secondary market is taxable.

If the sale proceeds of the bond exceeds its purchase price, then this is considered capital gain. The coupon rate of TFBs is benchmarked against government securities (G-secs) of equal maturity. So, for a 10 year lockin TFB, the benchmark would be 10- year G-sec rates. Coupon rate is calculated based on the type of investor, G-sec yield and the credit rating.

The tax benefit, when factored in, gives a comfortable yield on such investments. Here's an example: Instrument: 8.63 per cent IRFC 2029 Issuer: IRFC Maturity: 2029 Nominal coupon: 8.63 per cent Issued in: February 2014

Assuming the tax rate at 30 per cent, the pre-tax coupon on the bond will be 8.63 per cent/(1-tax rate)=12.33 per cent. Needless to say, this is attractive for any investor, be it institutional or individual.

Banks, as investors, have an additional advantage as of now. As per the Fimmda valuation guide lines, FBs can be valued for MTM purposes as per the traded data of similar bonds. If no traded data is available, the bond can be valued grossing up the tax benefit in the oupon. As TFBs are mostly not traded, the valuation gain as of now is an attractive benefit for banks. For example, the 8.63 per cent taxfree IRFC 2029 would be deemed to have a coupon of 13.08 per cent as below: Post-tax coupon = 8.63 per cent Pre-tax coupon x (1-tax rate) = 8.63 per cent (assuming tax rate at 34 per cent for corporates) Pre-tax coupon = 8.63 per cent/ (1- 0.34) = 13.08 per cent Effective pre-tax coupon = 13.08 per cent

By grossing up the tax benefit, the coupon is at 13.08 per cent and the valuation of the bond (reckoning coupon at 13.08 per cent) would be at Rs 135.35 (discounted current market yield at YTM 8.56 per cent). In other words, the bond that banks purchased at par value is valued at Rs 135.35. Needless to say, banks get sufficient cushion against any depreciation that may crop up in the valuation of other bonds in the same bucket.

Till AY08, banks have been enjoying the above double benefits in their portfolio of tax-free bonds. However, the situation changed in March 2008, when the government brought Rule 8D under IT Rules, which when read with Section 14A of the Income Tax Act, would require banks (according to the tax assessing officer) to net off the interest expense (taken as 5.50 per cent in our example), incurred for funding the TFBs and an operating expense 0.5 per cent from the nominal coupon before claiming tax benefit.

This means a bank cannot claim tax benefit on the entire coupon (8.63 per cent in our example). In other words, the effective tax free coupon is only 2.63 per cent (8.63 per cent-6 per cent). From AY09 onwards, banks have been assessed accordingly by the tax assessing officer.

Fimmda cautions that even the bond valuation, based on grossing up of tax benefits, can undergo a change because the tax benefit is only on 2.63 per cent (not on 8.63 per cent). Grossing up of coupon {2.63 per cent/ (1-0.34) = 3.98 per cent} would give an additional benefit of only 1.35 bps. This ould result in lesser valuation of TFBs as the taxable coupon is lesser at 9.98 per cent=8.63 per cent+ 1.35 per cent) vis-a-vis the valuat i o n ( at Rs 135.35) shown in the beginning.

Meanwhile, on May 30, 2014, the Income tax Appellate Tribunal, Pune passed an order for AY05 (based on the judgements of the high courts of Gujarat andBombay), according to which, the nvestment in TFBs made out of interest- free owned funds are exempt from the netting off of the interest cost (which in our above example is 5.50 per cent). In that case, only the operational expense at 0.5 per cent need be reckoned. Then the pre-tax coupon would work out to 12.81 per cent.

New tax-free bonds may click with individual investors, not banks

Perhaps after taking a cue from the Appellate Tribunal Order, some banks have reportedly gone in appeal against the decision taken by the tax assessing officer. A decision on the appeal is pending.

Meanwhile, the government has announced new TFBs in this fiscal amounting to Rs 40,000 crore to be issued by entities such as National Highway Authority of India, Indian Railway Finance Corporation, Housing & Urban Development Corporation (Hudco), Indian Renewable Energy Development Agency, Power Finance Corporation (PFC), Rural Electrification Corporation and National Thermal Power Corporation. PFC and Hudco have already issued TFBs in July 2015.

How do investments in recently-issued tax-free bonds compare with the investment in normal taxable bonds? The recently-issued bonds — 7.16 per cent PFC 2030 and 7.19 per cent Hudco 2030 — would carry, as of now, a pre-tax coupon of 7.76 per cent and 7.80 per cent respectivelyfor banks (after netting off the funding cost @ 5.50 per cent and operational expense @ 0.5 per cent and taking tax rate @ 34 per cent), and 10.23 per cent and 10.27 per cent respectively for individual investors (taking tax rate at 30 per cent). It is obvious that the investment in TSBs is still attractive to individual investors whereas for banks the investment no longer looks enticing as G-secs are available at a better rate for the same tenure.

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