Should you invest in capital gain bonds to save tax?
One of the common questions raised by taxpayer in my various tax seminars is with regard to tax saving option U/s 54EC which exempts Long Term Capital Gain (LTCG) if amount is invested in specified bonds issued by National Highway Authority of India (NHAI) or Rural Electrification Corporation (REC). The question has become all the more relevant in view of the fact that the lock in period for exemption u/s 54EC has been raised from 3 years to 5 years and the bond offers interest in the range of 5%-6%. Personal experience shows that the businessmen having borrowed fund with high cost also invests in 54EC bonds to save tax even if repayment of loan would have been a better option for such taxpayers.
Let us understand whether it is worthwhile to invest in the specified bonds which presently offers meager rate of 5.75% just to save tax @ 20.80%.
About Section 54EC:
Section 54EC provides that any LTCG earned from sale of any long term assets will be exempt from tax if the amount is investedwithin a period of 6 months from the date of transfer of assets in the specified bonds issued by NHAI/REC. It is available to all the categories of taxpayers whether it is individual, HUF, Companies, firm etc. Further, it is available to all the classes of assets, be it land, building, gold, gems, tenancy rights, etc. There is a ceiling of Rs. 50 Lakh for exemption u/s 54EC which means that the amount exceeding Rs. 50 Lakh can never be the part of LTCG exemption u/s 54EC. The bonds are fully secured and it is presently offering interest @ 5.75%, payable annually. Interest is taxable and not exempt from tax. Exemption u/s 54EC is available on the basis of LTCG & not with reference to “Net Sale Consideration” which means that entire net sale consideration need not be invested for claiming exemption u/s 54EC. It may be noted that all LTCG in general is taxable at a special rate of 20%. With education cess of 4%, the effective rate turns out to be 20.80%
To know whether it is worthwhile to invest in 54EC bonds or not, we need the spreadsheet to work out the value of the of fund after 5 years if
(a) amount is straightway invested in specified bonds to save tax of 20.80% and
(b) Tax is paid straightway @ 20.80% & the balance of 79.20% is invested elsewhere which illustratively may be offering return in the range of 12% to 20%. Let us assume that the person who is 30% tax bracket (effective rate= 31.20% with education cess of 4%) has earned a LTCG of Rs. 1 Lakh. Let us know the fund value after 5 years.
Option A
The biggest advantage with option A is that the taxpayer will be able to retain entire amount of LTCG as against option B wherein they would be left with 79.20%. The value of the fund at the end of each year & after 5 years will be as under:
| Particulars | Interest | Tax | Interest | Year end |
| after Tax | Value | |||
| 1st Year | 5,750 | 1794 | 3956 | 103956 |
| 2nd Year | 5,977 | 1865 | 4112 | 108068 |
| 3rd Year | 6,218 | 1940 | 4278 | 112346 |
| 4th Year | 6,472 | 2019 | 4453 | 116800 |
| 5th Year | 6,741 | 2103 | 4638 | 121438 |
| Total Funds | 31,159 | 9,722 | 21,438 | 121,438 |
It is presumed that interest received above is invested in other secured securities yielding same rate of return.
Option B
The taxpayer will be left with only 79.20% amount which can be invested in business, mutual funds or anywhere at the prevailing market rate. The return would vary from person to person.
| Expected Rate of Return | 12.00% | 13.00% | 13.50% | 14.00% | 16.00% | 18.00% | 20.00% |
| Tax @ 31.20% | 3.74% | 4.06% | 4.21% | 4.37% | 4.99% | 5.62% | 6.24% |
| Post Tax Return | 8.26% | 8.94% | 9.29% | 9.63% | 11.01% | 12.38% | 13.76% |
| 1st Year post tax Interest | 6,539 | 7,084 | 7,356 | 7,629 | 8,718 | 9,808 | 10,898 |
| 2nd Year post tax Interest | 7,079 | 7,717 | 8,039 | 8,363 | 9,678 | 11,023 | 12,397 |
| 3rd Year post tax Interest | 7,663 | 8,407 | 8,786 | 9,169 | 10,743 | 12,388 | 14,103 |
| 4th Year post tax Interest | 8,296 | 9,159 | 9,602 | 10,052 | 11,926 | 13,922 | 16,044 |
| 5th Year post tax Interest | 8,981 | 9,979 | 10,494 | 11,020 | 13,239 | 15,646 | 18,252 |
| Total Return in 5 years | 38,557 | 42,346 | 44,277 | 46,233 | 54,305 | 62,787 | 71,694 |
| Value after 5 years | 117,757 | 121,546 | 123,477 | 125,433 | 133,505 | 141,987 | 150,894 |
Comparison of option A & option B will make it obvious that if the taxpayer is able to earn more than 13% than ‘Paying tax would be a better option than saving tax’. Of course, the above example is for taxpayers who are into 30% tax bracket. For taxpayers who are in to 20% tax bracket, the above spreadsheet will depicts that the value of Rs. 1 Lakh after 5 years will be Rs. 1,24,941 under option A and person with return above 7.15% can opt for paying tax.
Above was an attempt to provide an analysis of tax saving option vis a vis alternate investment avenues with the taxpayers offering higher returns. However, taxpayer should note that 54EC bonds are secured & offers fixed returns. Above chart may enable readers to take an informed & calculated decision.
[By the FA-2018, LTCG arising from Shares is taxable @ 10% if the amount exceeds Rs. 1 Lakh. Readers can also opt for section 54EC exemption against such LTCG subject to the concept discussed above].
[Readers may forward their feedback & queries at nareshjakhotia@gmail.com. Other articles & response to queries are available at www.thetaxtalk.com ]
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