Non-convertible debentures (NCD) are the flavour of the season and as many as six issues have hit the market so far in 2019. While investors are busy focussing on the higher interest rate offered by most NCDs, some distributors and chartered accountants are taking advantage of a tax misinterpretation concerning the cumulative interest option on NCDs.
NCDs are fixed-return instruments issued by companies when they want to borrow money. Typically, NCDs come with a credit rating; the higher the rating, the lower are the coupons paid, and vice-versa.
Most NCDs provide the option of receiving interest payments either monthly, quarterly or annually. However, many offer an added option of receiving interest on a cumulative basis. In the cumulative interest option, investors do not receive interest payments throughout the NCD’s tenure but as a lump sum amount on maturity.
Investors are often confused if this cumulative interest received on maturity is to be treated as a capital gain or interest income.
Take a look at Shriram City Union Finance NCD issued on April 5, 2019. A Rs 1,000 investment in its 24-month cumulative option fetches Rs 1,200.15 at maturity. In the case of India Infoline Finance NCD that hit the market in January 2019, Rs 1,000 invested in a 39-month cumulative option fetches Rs 1,346.63 at maturity, a yield of 9.60 percent, as per its prospectus.
Industry insiders point out that cumulative NCDs are marketed more and often mis-sold as capital gains instruments. This means the gain made from the time of investment to maturity is simply treated as capital gains. “There is mis-selling going on in the case of cumulative NCDs. Here, the gain is supposed to be treated as interest income, and not capital gain. Instead, some chartered accountants and distributors are mis-selling this as capital gain NCD and misleading investors that the income from cumulative options is to be treated as capital gains,” said a large distributor of NCDs and financial products who requested anonymity.
In fact, a prominent chartered accountant contacted by Moneycontrol said: “The gains from a cumulative option of NCD is to be treated as capital gains, with or without indexation benefits, depending on how it works out.”
The distributor quoted above said even sales officials of some NCD-issuing companies mis-sold the cumulative option as capital gains instruments. Moneycontrol couldn’t independently verify on companies involved.
Check out the table below:
For all the cumulative options, the tax works out to be lowest if treated as capital gains. The 10 percent long-term capital gains tax works out to be the lowest tax-paying option, even as opposed to the 20 percent tax with indexation option, but that is also probably because of low inflation in recent years. Both the capital gains options, however, work out to be far more tax-friendly than if your income is taxed as interest income (if you are in the highest tax slab).
Homi Mistry, Partner, Deloitte India clarifies: “Yes, the cumulative option is also interest income. This is not your capital gain.”
To be sure, bonds listed on stock exchanges and that are in dematerialised form attract long-term capital gains tax on sale after a year. Most bonds these days come in dematerialised form. Profit earned from the sale of such bonds within a year is termed as short-term capital gains that are added to the income and taxed at the applicable income tax rate.
“Here as well, remember the tax laws say that you have to split the gains between interest accrued and capital gain. The former gets taxed at your income tax rate and the latter gets taxed at capital gains tax rate,” said Ajay Manglunia, an independent professional who specialises in fixed income investments.
But if bonds are held to maturity and a lump sum amount (in the cumulative option) is received, most tax experts rightly concur the income as interest income, even though no interest is received throughout the bond's tenure.
So why does the growth plan of a mutual fund, when bought and sold, lead to a capital gain or loss with taxes applicable accordingly. “That’s because in the case of a mutual fund, the net asset value is marked-to-market and it goes up and down with the market. There is no assurance of an income there, unlike an NCD where you get assured interest,” said Tivesh Shah, Chief Executive Officer, Tru-Worth Finsultants, a consulting firm for independent financial advisers.
The prospectus of L&T NCD shed some light on the matter. “…cumulative or regular returns on debentures held till maturity would generally be taxable as interest income taxable under the head Income from other sources where debentures are held as investments or business income where debentures are held as trading asset/stock in trade...".
The prospectus of Muthoot Homefin (India) also said the same.
Remember to file your cumulative income as interest income and not as your capital gains.