If the bond pays the entire interest at the time of maturity, then you have the option of paying the tax on accrual basis or on receipt basis. But whichever option you choose, you have to use that mode for entire bond portfolio. Investment experts say that it is better to pay tax on accrued interest than on interest receipts basis, if you do not intend to sell the bond before maturity. “Investors would be better off to take the accrual route in case of cumulative bonds as that will help in avoid high tax liability, when there is large amount received on maturity,” says Balwant Jain, tax and investment expert.
If the bond you have bought is a zero coupon bond — that is a bond that mentions only issue price and redemption amount but does not specify the rate of coupon, then at the time of redemption the gain is treated as capital gain. “Zero coupon bonds do not pay interest to bondholders. On maturity, in case of zero coupon bonds notified by the central government, the difference between maturity price and issue price is taxed as long-term capital gains in the hands of the bondholder. In case of maturity of other zero coupon bonds, the difference is taxed as interest,” Archit Gupta, founder & chief executive officer ClearTax, pointed out. Along with interest income, bonds are also subject to taxes on capital gains.
Tax treatment on holding period: The capital gains are defined as long-term capital gain or short-term capital gain. However, the norm pertaining to holding period required changes depending on the ‘listing status’ of the bond. In case of bonds listed on the stock exchange, the gains pocketed on sale of bonds held for more than 12 months are treated as long-term capital gains. But if the bond is not listed, then the gains earned on sale of bonds held for more than 36 months are treated as long-term capital gains.
For gains earned on shorter tenure are treated as short term capital gains and taxed at marginal rate of tax of the investor.
Rate of tax: Long-term capital gains arising on listed securities are taxed at 10 per cent. But in the case of government securities and zero coupon bonds, the investor has the option to pay tax at flat 10 per cent or at the rate of 20 per cent after applying indexation benefit, lower of the two.
“Since the zero coupon bonds has 0 per cent interest rate, there is no taxability of interest thereon and long-term capital gains shall be taxed at above-mentioned rates,” Maheshwari says.