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Zero Coupon Bonds (ZCB) & its taxation in the hands of investor & issuer Company along with TDS provision
– CA Naresh Jakhotia
Zero Coupon Bonds are the financial instruments in which no interest as such is payable. That’s why it is called as “Zero” coupon bonds i.e., no interest is specified on the bonds. It is issued at a discounted price as compared to the final maturity value which is mentioned over the bonds.
For example, the company issuing zero coupon bond mentions Rs. 100 as its maturity value, say after a period of 5 years. It will be issued by the company at a discounted price of say Rs. 70/- which means that by investing Rs. 70/-, investor will get Rs. 100/- at the end of 5th year.
Difference of Rs. 30 is referred to as the discount. This is almost can be equated with interest. Normally, discount is calculated by the issuer keeping the interest rate in mind. The investor is sure of the amount it will be receving at the end of the tenure and the amount receivable at the end of the tenure is termed as face value.
The discount represents the interest income of the investor over the period of investment.
Zero Coupon Bond under the Income Tax Act-1961
There is specific definition given in the Income Tax Act-1961 in section 2(48).
Section 2(48) of Income Tax Act, 1961 defines Zero Coupon Bonds reads as under:
Unless the context otherwise requires, the term “zero coupon bond” means a bond-
(a) issued by any infrastructure capital company or infrastructure capital fund or public sector company or scheduled bank on or after the 1st day of June, 2005;
(b) in respect of which no payment and benefit is received or receivable before maturity or redemption from infrastructure capital company or infrastructure capital fund or public sector company or scheduled bank; and
(c) which the Central Government may, by notification in the Official Gazette, specify in this behalf.
For the purposes of this clause, the expression “scheduled bank” shall have the meaning assigned to it in clause (ii) of the Explanation to sub-clause (c) of clause (viia) of sub-section (1) of section 36*.
* “scheduled bank” means the State Bank of India constituted under the State Bank of India Act, 1955 (23 of 1955), a subsidiary bank as defined in the State Bank of India (Subsidiary Banks) Act, 1959 (38 of 1959), a corresponding new bank constituted under section 3 of the Banking Companies (Acquisition and Transfer of Undertakings) Act, 1970 (5 of 1970), or under section 3 of the Banking Companies (Acquisition and Transfer of Undertakings) Act, 1980 (40 of 1980), or any other bank being a bank included in the Second Schedule to the Reserve Bank of India Act, 1934 (2 of 1934).
Taxation of Zero Coupon Bonds
Unlike other bonds, debentures or FDR Investment, investments in zero coupon bonds doesn’t yield any regular benefits during the continuation of its tenure, i.e. no interest or other benefits is are received or receivable from the investments before its maturity orredemption.
As a result, annual income is not required to be offered for taxation on accrual basis as is generally done in the case of FDR.
Taxability normally would depend upon the nature of investment by the investor. Investment could be either capital investment or business investment by the investor. If zero coupon bonds investment is held as capital asset then income from transfer, sale or redemption etc shall be taxable under the head “Income from Capital Gains” whereas if the same is held as Business investment or held as stock-in-trade then the , income from sale, transfer or redemption etc shall be taxable under the head “Profits & Gains from Business or Profession”.
In either case, no income accrues during the period of holding and so no income is taxable on accrual basis during the period of its holding unless & until there is a transfer of zero coupon bonds by reason of sale, transfer, redemption etc
Sale, Maturity, Redemption or otherwise transfer of zero coupon bonds is considered as “Transfer” in the hands of investor for levy of capital gains tax under S.2(47)(iva). Income arising from zero coupon bonds shall be taxed only in the year in which same is transferred or redeemed or matured. The income arising from transfer of zero coupon bonds could be either Short Term Capital Gain (STCG) or Long Term Capital Gain (LTCG) depending upon the period of holding. If held for more than 12 months than it will yield LTCG, else STCG.
Proviso to Section 112(1) of Income Tax Act-1961 clarifies the process of calculating tax on LTCG arising from transfer of zero coupon bonds. It provides that in cases where the tax payable in respect of LTCG arising from transfer of a zero coupon bonds exceeds 10% of the amount of capital gains without indexation then such excess shall be ignored.
Treatment of discount in the hands o f the Issuer Company or Fund
Most important is the treatment of discount figure in the hands of the issuer.
There is a specific provision for this. S.36(iiia) of Income Tax provides that the fund or company which issues the zero coupon bonds shall be entitled to claim deduction on pro-rata basis for the amount of discount on the zero coupon bonds considering the tenure of such bond, in the manner as may be prescribed.
For the purposes of allowing pro-rata deduction to the issuer company:
(i) “Discount” means the difference between the amount received or receivable by the infrastructure capital company or infrastructure capital fund or public sector company or scheduled bank issuing the bonds and the amount payable by such company or fund or public sector company or scheduled bank on maturity or redemption of such bonds;
(ii) “period of life of the bonds” means the period commencing from the date of issue of the bonds and ending on the date of the maturity or redemption of such bonds;
TDS Not Applicable on Maturity/ Redemption
There is a specific exclusion provided for this. Section 194A(3)(x) provides the exclusion. TDS is not applicable on income or maturity/redemption proceeds of zero coupon bonds.