Tax Treatment of Inflation-Linked Bonds

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	Last week the Reserve Bank of India announced the launch of the much- awaited Indexed National Savings SecuritiesCumulative (IINSS- C) bonds. These bonds will be available between December 23 and 31, 2013. They were announced in the Union Budget 2013- 14 as the kind of securities to protect savings from inflation. The face value of the bond increases in line with an inflation index while a small interest rate is paid on the face value. What does this mean? To put it simply, whatever the investor gains from the higher face value is compensation for inflation. The interest rate paid is the actual income. At the end of the term the entire accumulated amount is added to an investor's income and taxed at the applicable tax slab rate. Salient features of the IINSS- C bonds Bonds issued by the government pay interest at a rate linked to the consumer inflation rate. The rate of interest comprises 1) a fixed rate of 1.5 per cent and 2) an "inflation" rate based on the Consumer Price Index ( CPI), compounded half yearly. Minimum investment of ₹ 5,000; face value of a bond is ₹ 100. Maximum investment of ₹ 5 lakh per annum per applicant. Tenure of the bond is 10 years. Interest income is taxable. Must be declared and tax paid even if it is compounded. Only for individuals, HUFs, and charitable trusts. Not for NRIs. However, they can be nominated by a bond holder. Not for companies and financial institutions. Credit risk is very low as this is backed by the government. Re- investment risk is very low because the interest is compounded, and one does not have to find other investment avenues for re- investing the returns. Redemption of the bonds after three years, except for senior citizens, who can redeem after a year. The early- redemption penalty is high. One can redeem only a few days before the coupon rates. That would happen once every six months. The penalty for early redemption is half the last coupon paid. When inflation is high, the penalty too is high. How is interest calculated? The investor receives an inflation rate ( according to the CPI) plus 1.5 per cent per year. When an investor purchases a bond, the base inflation index is the one three months earlier. Interest is calculated every six months as below: Interest = percentage change in the CPI for the last six months +0.75 per cent ( at 1.5 per cent per year) In the past one year CPI has hovered around 10 per cent. So the return in such a scenario would be inflation plus 1.5 per cent, that is, 11.5 per cent. Not bad for someone who does not have to pay taxes, or falls within the lower tax bracket. The interest payout has a minimum value of 1.5 per cent. This means that even if inflation is negative, one would still get at least 1.5 per cent return on investment in such bonds. Tax treatment The interest is added to the principal ( the compounding concept), and taxed under the head "Income from other sources", not as capital gains even though the entire amount is received on maturity. Like National Savings Certificates, you must declare the interest every year as income and pay tax on it even though the money is not actually received as cash in your account. These bonds do not fall within the list of deductions under Sec 80C. The interest would be subject to the income tax slab rate applicable to you. Should you invest? If the inflation- compensating part had been capital gains, it could have benefited from indexation. The IINSS has a high rate of return as inflation is high, but has the disadvantage as well as of a long lock- in period of 10 years. Early redemption is available only after three years on payment of apenalty. Also there's a cap of ₹ 5 lakh per investor. Other options: Tax-Free Bonds such as those of NTPC offer 8.66 per cent ( tax free) on a 10- year tenure, with the possibility of selling early in the market. Public Provident Fund also offers 8.7 per cent taxfree interest though with a lockin of 15 years. Liquid funds and Fixed Maturity Plans also offer 9per cent returns post- tax if held for a year or more. But this is not guaranteed over 10 years. Clearly, from the calculation the IINSS is not attractive to retail investors in the higher tax- bracket or for senior citizens, who look for regular income. If the CPI falls, the returns slide proportionately. In that case, investing in taxfree bonds is far better. Also, companies that are permitted to issue tax free bonds are public sector undertakings, which are all highly rated companies. With good-credit-rated bonds, one has much better returns, net of tax, annually, with much lower risk.

 

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