Selling cumulative bonds before maturity: Is the gain taxed as LTCG or interest income?

Bonds

• Cumulative bond profits taxed as long-term gains at 12.5%.
• No need to split sale price into interest and capital gains for cumulative bonds
• If held till maturity, difference is taxed as interest income on receipt basis

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Understanding the tax implications of selling long-held cumulative bonds can be tricky, especially when interest has not been received periodically. Today's Ask Wallet Wise query explores whether gains from selling such bonds are taxed purely as capital gains or partly as interest income.

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I am holding 100 NCDs of IFCI bonds allotted in August 2011 with an issue price of Rs 10,000 and a maturity value of Rs 46,255 due to mature in August 2026. I propose to sell these bonds now in the secondary market through stock exchange at a price of Rs 42,000 per NCD.

My question is whether the profit earned attracts only Long Term Capital Gains (LTCG) at the rate of 12.50 percent or both interest income as per slab rate on the accumulated interest (which I have not received as the bonds are cumulative in nature) and  LTCG on the capital gains . Kindly clarify. 

Expert's Advice: This is really very interesting question. The bonds carry fixed rate of interest. In respect of business income and income from other sources the tax payers have option to offer their income on accrual basis or on receipt basis.

Since the interest from bonds generally gets taxed under the “Income from Other Sources” head, you had the option to offer the accrued interest on accrued basis every year since the year of issue. It seems that you have not offered the interest income on accrual basis in the past.

There are no clear cut provisions under the income tax laws about the tax treatment in such situation. The bond prices on the stock exchange does not only comprises of the accrued interest and principal amount but also includes discount or premium in the price of the bonds due to difference between prevailing interest rate as compared to the coupon rate offered on such bonds.

For this reason, the cumulative bonds carrying fixed coupon rate can be treated as capital asset. Any profit or loss made on sale of such bonds should logically be taxed under the head capital gains. There are no provisions which require you to bifurcate the sale price into interest and capital gains.

So the difference between the issue price and the rate at which the same are sold on the stock exchange should be treated as capital gains. Since the bonds are listed and have been held for more than 12 months the profits will be taxed as long term capital gains at flat rate of 12.50 percent. However, in case you hold these bonds till its maturity the difference between the issue price and the redemption price would be taxed as interest income on receipt basis.

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