Debt instruments are used by many entities to raise funds from the market. Debt instruments are similar to giving a loan to the issuing entity by the investor. The person holding the debt instrument of an entity would not hold any voting power or dividend claim. However, he is entitled to receive interest and redemption value at the time of maturity from the entity.
Sources of Income from Debt Products:
- Periodic income earned from debt instruments is classified as interest income.
- The gain or loss arising from transfer or redemption of debt instruments is classified as capital gains and taxed as such.
Interest income:
- The income in the nature of interest on securities is taxable under the head ‘income from other sources’ if it’s not taxable under the head business income.
- Two methods of accounting are allowed under the Income-tax Act, namely, the mercantile system and cash system, whichever is regularly employed by the assessee.
- If the assessee follows the mercantile system of accounting, interest on securities is taxable on an accrual basis. If he follows the cash system of accounting, it is taxable on a receipt basis.
- The taxable income in the nature of interest on securities is calculated by deducting permissible deductions (like collection charges, interest on loans taken to debt purchase securities) from gross interest from securities.
Capital gains:
- Gain or loss arising from transfer or redemption of any security including debt securities is chargeable to tax under the head capital gain if the same is held by the assessee as a capital asset, that is, as an investment.
- Securities held by foreign portfolio investors (FPIs) are always treated as a capital asset.
- Tax on capital gain depends upon many factors such as nature of security, the period of holding, residential status of the assessee, etc.
- Certain types of transfer from the scope and meaning of the word ‘transfer’ in relation to a capital asset are excluded from capital gain.
Types of Debt Products-
Coupon Bonds-
| Types of Debt Products | Coupon Bonds |
|---|---|
| Definition | Bonds issued and redeemed at face value, with interest paid to investors over the tenure of the bond. Key features include maturity, coupon, and principal. |
| Coupon Bonds | Bonds with a coupon rate, where lenders are entitled to periodic interest payments. |
| Market Value | Determined by computing the present value of all future cash flows, using the yield-to-maturity. |
| Tax on Interest | Interest from bonds is taxable under the head other sources and is generally taxed at a normal rate. Deductions are allowed for expenses laid out or expended to earn interest income, and commissions paid to realize such interest. |
| Concessional Rates | Some cases offer concessional tax rates, including interest received from the government or Indian concern on foreign currency, Infrastructure Debt Funds, long-term infrastructure bonds, and more. |
Zero-Coupon Bonds and Deep Discount Bonds-
| Topic | Zero Coupon Bonds | Deep Discount Bonds |
|---|---|---|
| Description | Do not carry any coupon or interest | Issued at a steep discount to face value |
| Issuer | Various entities | Public financial institutions (e.g. SIDBI, IDBI, ICICI) |
| Redemption | Redeemed at face value at maturity | Redeemed at face value at maturity |
| Taxation | Profit or gain on redemption is taxable as long-term capital gain if held for more than 12 months | Long-term capital gain taxed at 10% without indexation |
| Benefit | Capital gains arise from the difference between issue price and face value | High return potential due to low issue price |
| Risks | Fluctuation in interest rates affects bond prices | Credit risk of the issuer |
| Examples | Treasury bills, savings bonds | Infrastructure bonds, government bonds |
Convertible Bonds-
| Topic | Convertible Bonds |
|---|---|
| Definition | A type of bond that allows the bondholder to convert their bonds into equity shares of the issuing corporation on pre-specified terms. |
| Conversion Ratio | Refers to the number of equity shares issued in exchange for the bond being converted. |
| Conversion Price | The resulting price when the conversion ratio is applied to the value of the bond at the time of conversion. |
| Fully Convertible Bonds | Bonds that are fully redeemed on the date of conversion. |
| Partially Convertible Bonds | Bonds that are redeemed in part, and equity shares are issued in the pre-specified conversion ratio. The non-convertible portion continues to remain as a bond. |
| Taxability | Any conversion of bonds into shares or any other asset is considered an “exchange” and falls under the definition of transfer, subject to capital gain tax. However, conversion of bonds into shares or debentures of the company is not considered a transfer under Section 47 of the Income-tax Act. |
| Section 47 | Transactions relating to the conversion of securities that are not treated as a transfer. Includes conversion of bonds into shares, and conversion of foreign currency exchange bonds issued to non-residents by Indian companies. |
| Cost of Acquisition | When a person subsequently sells shares or debentures acquired through conversion of bonds, the cost of acquisition shall be the same as that of the bonds, and the period of holding shall be reckoned from the date of acquisition of the bonds. |
Commercial Paper-
| Aspect | Details |
|---|---|
| Definition | Unsecured money market instrument in the form of a promissory note |
| Introduction in India | 1990 |
| Purpose | To diversify short-term borrowings for highly rated corporate borrowers and provide an additional investment instrument |
| Issuers | Corporate and financial institutions |
| Investors | Individuals, banking companies, corporates, non-corporates, NRIs, FPIs (within SEBI limits) |
| Maturity Period | Minimum 7 days, maximum 1 year |
| Trading | Actively traded in the OTC market |
| Taxability of Difference between Face Value and Issue Price | Treated as ‘discount allowed’, not as ‘interest paid’, hence not taxable as interest income. |
| Taxability for Non-Resident Investors | Tax to be deducted at the rate of 30% for non-resident payees and 40% for foreign company payees as per Section 195 of Income-tax Act |
| Taxability of Capital Gains | Any gain arising on transfer/redemption of commercial papers is taxable as short-term capital gain, applicable tax rates for residents and non-resident persons, and foreign companies. FPIs will be taxed at a flat rate of 30% under Section 115AD. |
Government Securities-
| Government Securities | Description |
|---|---|
| Definition | A tradable instrument issued by Central or State Government to acknowledge the Government’s debt obligation. |
| Short-term Securities | Treasury bills or Cash Management bills with a maturity of less than 1 year. |
| Long-term Securities | Government bonds or Dated Securities with a maturity of 1 year or more. |
| State Development Loans (SDLs) | Bonds issued by State Governments with a maturity of 1 year or more. |
| Safety of Investment | G-Secs are considered as the safest investment instrument as they carry practically no risk of default. |
| Dematerialized Account | Investors can hold G-Secs in a dematerialized account with a depository (NSDL/CDSL). |
| Types of Government Securities | G-Secs are available in a wide range of maturities ranging from less than 91 days to as long as 40 years. |
| Cash Management Bills (CMBs) | Highly flexible bills with a maturity period usually less than 91 days. |
| Treasury Bills (T-Bills) | Short-term debt instruments issued in 3 tenors- 91 days, 182 days, and 364 days. |
| Dated Government Securities | Bonds issued by the RBI on behalf of the Government with a fixed or floating coupon paid on a half-yearly basis. |
| Taxation of Cash Management Bills and T-Bills | No interest to investors. Profit on redemption or transfer considered as a short-term capital gain. Tax rate is applicable in case of an assessee. Tax for foreign portfolio investors is charged at a rate of 30%. |
| Taxation of Dated G-Secs and SDLs | Taxability is the same as in the case of bonds. No tax is required to be deducted from the payment of interest to a resident person in respect of securities of Central Government or State Government except in the case of 8% Savings (Taxable) Bonds, 2003 and 7.75% Savings (Taxable) Bonds, 2018. Tax on interest paid in respect of these bonds is required to be deducted by the payer only when the amount of interest paid during the year exceeds Rs. 10,000. |
Tax-Free Bonds-
| Topic | Tax Free Bonds |
|---|---|
| Definition | Bonds that provide tax-free income to investors |
| Taxability of Income | Interest paid on these bonds is tax-free in the hands of the investor |
| Exemptions | Section 10 of the Income-tax Act provides various exemptions for the income earned from bonds issued by various organizations |
| Taxability of Capital Gains | Same as coupon bonds (Refer Section 10.2.1) |
Mutual Funds:
- Collect money from investors and invest in the capital market
- Invest in a variety of instruments such as equity, debt, bonds, etc.
Types of Mutual Funds:
| Type | Description |
|---|---|
| Equity Oriented Funds | Invest mainly in shares of companies, allowing investors to participate in the equity market. High risk, but potential for high returns in the long run. |
| Debt Oriented Funds | Invest in debt securities or interest-bearing instruments like government securities, bonds, debentures, etc. Provides low return but considered safe for investment compared to equity funds. |
| Money Market Funds | Invest in liquid instruments such as Treasury Bills and Commercial Papers, having high liquidity. Suitable for conservative investors who want to invest surplus funds for a short-term for a reasonable return. |
| Balanced or Hybrid Funds | Invest in all kinds of assets – equity, debt, and money market instruments. Some invest the majority in equity and the lesser in debt, while some opt for the other way around based on their needs for return and risk appetite. |
Taxation of Income from Mutual Funds (Debt-Oriented)
| Type of Income | Tax Treatment |
|---|---|
| Dividend | Taxable as per applicable tax rates for resident unit-holders. Deduction allowed for interest expenditure up to 20% of total income. No deduction allowed for other expenses. |
| Long-Term Capital Gains | Taxable at 20% plus surcharge and cess after taking benefit of indexation for units held for more than 36 months. Non-residents are taxed at 20% plus surcharge and cess without indexation benefit. |
| Short-Term Capital Gains | Taxable as per applicable rates for the assessee. |
In this example, Mr. A acquired 1,000 units of a debt-oriented mutual fund at Rs. 150 per unit on 01-01-2016 and sold them on 15-03-2020 at Rs. 300 per unit. The period of holding is more than 36 months, so the nature of capital gain is long-term capital gain.
To calculate the capital gain, we need to determine the Full Value of Consideration, which is calculated as follows:
Full Value of Consideration = Number of units sold x Sale price per unit
= 1,000 x 300
= Rs. 300,000
Next, we need to calculate the Indexed Cost of Acquisition. The cost of acquisition of capital asset is Rs. 150 per unit, so the total cost of acquisition is Rs. 1,50,000.
The CII for the financial year 2015-16 is 254 and for the financial year 2019-20 is 289. Therefore, the indexed cost of acquisition is calculated as follows:
Indexed Cost of Acquisition = Cost of Acquisition x CII of the year of transfer / CII of the year of acquisition
= 1,50,000 x 289 / 254
= Rs. 1,70,669
Long-term capital gain is calculated by subtracting the indexed cost of acquisition from the full value of consideration:
Long-term capital gain = Full Value of Consideration – Indexed Cost of Acquisition
= Rs. 3,00,000 – Rs. 1,70,669
= Rs. 1,29,331
The tax rate on long-term capital gain is 20%, so the tax liability of Mr. A will be Rs. 25,866.2 (20% of Rs. 1,29,331).
Masala Bonds
- Masala Bonds are Rupee Denominated Bonds (RDBs) issued to overseas investors but linked to the Indian currency.
- The name “Masala” reflects the spiciness and culture of India.
- They protect Indian companies from currency risk and transfer the risk of currency fluctuation to investors buying these bonds.
- Any corporate or body corporate is eligible to issue RDBs overseas, including Real Estate Investment Trusts (REITs), Infrastructure Investment Trusts (InvITs), and banks.
- The borrowing procedure for RDBs follows the same guidelines as for External Commercial Borrowings (ECBs).
- Interest on Masala Bonds is taxable at concessional rates depending on the assessee and the type of bond.
- Long-term capital gains arising from transfer or redemption of Masala Bonds are taxable at the same rate as coupon bonds, with some exceptions.
- Short-term capital gains are taxable at normal rates for most assessee but at a flat rate of 30% for Foreign Portfolio Investors (FPIs).
- Certain transactions, such as transfer of RDBs between non-residents outside India or on a recognized stock exchange in an International Financial Services Centre (IFSC), are not regarded as transfers.
Foreign Currency Convertible Bonds (FCCBs)
Foreign Currency Convertible Bonds (FCCBs) are equity-linked debt securities issued by corporate entities, international agencies, or sovereign states in a freely convertible foreign currency. Investors can convert them into shares or depository receipts according to a predetermined formula or exchange rate, or they can choose to retain the bond.
FCCBs offer lower interest costs to the issuer than similar non-convertible debt instruments due to their convertibility nature. They are also freely tradable, like Global Depository Receipts (GDRs), and the issuer has no control over the transfer mechanism.
FCCBs are an approved instrument for accessing external commercial borrowings (ECBs), and the terms and conditions applicable to ECBs also apply to convertible bonds.
Interest on FCCBs is taxable at the same rate as coupon bonds, but non-residents’ interest on FCCBs issued by an Indian or Public Sector Company is subject to a concessional tax rate of 10% under Section 115AC of the Income-tax Act, 1961. No deductions are allowed from such interest income, including those under Sections 80C to 80U.
Taxability of capital gains arising from the transfer of FCCBs is the same as for coupon bonds, but long-term capital gains on FCCBs issued by an Indian or Public Sector Company are taxable at a rate of 10% for non-residents under Section 115AC of the Income-tax Act, 1961.
Transfers of FCCBs of an Indian company by a non-resident to another non-resident outside India are not treated as transfers if the bonds were purchased in foreign currency under a scheme approved by the Central Government. Transfer of FCCBs on a recognized stock exchange located in any International Financial Services Centre is also not considered a transfer provided the consideration is paid or payable in foreign currency.
Financial Securities-
Financial securities are instruments that represent ownership or creditorship in a financial asset, such as stocks, bonds, and options. One type of financial security is Pass-Through Certificates or Securitised Debt Instruments. These are debt securities that are created from a select pool of assets, such as debt or receivables of an enterprise. The process involves pooling together a large number of loans given by an enterprise and transferring the proceeds arising from these loans to the holder of securitized debt instruments.
This process is carried out by a Special Purpose Vehicle (SPV), which acquires the debt or receivables from the originator, or the entity that holds the assets. The SPV then issues securities backed by the debt or receivables, which are called Pass-Through Certificates. The income from the debt or receivables is transferred by the SPV to the security holder. If the debt or receivables are secured by a mortgage, the securities issued by the SPV are also called Mortgage-Backed Securities or Asset-Backed Securities.
The public offer and listing of these instruments are regulated by SEBI through the SEBI (Issue and Listing of Securitised Debt Instruments and Security Receipts) Regulations, 2008. Important terms to understand this process include Originator, Asset Pool, Securitisation, Special Purpose Distinct Entity (SPV), and Investor, all of which are defined in the regulations.
Here is a table summarizing the key terms:
| Term | Definition |
|---|---|
| Originator | The entity that assigns debt or receivables to an SPV for securitization |
| Asset Pool | The total debt or receivables assigned to an SPV in which investors have a beneficial interest |
| The acquisition of debt or receivables by an SPV for issuance of securitized debt instruments to investors | Any person holding securitized debt instruments that acknowledge their interest in the assigned debt |
| Special Purpose Distinct Entity (SPV) | A trust that acquires debt or receivables and issues securitised debt instruments |
| Investor | A trust that acquires debt or receivables and issues securitized debt instruments |
SARFAESI Act and Security Receipts:
- Security Receipts are receipts or securities issued by a trust set up by an Asset Reconstruction Company to any Qualified Buyer, evidencing the purchase or acquisition by the holder thereof, of an undivided right, title or interest in the financial asset involved in securitization.
- Asset Reconstruction Companies (ARCs) are created to manage and recover Non-performing Assets (NPAs) of Banks and Financial Institutions. Essentially, ARC functions as a specialized financial entity which isolates NPAs from the balance sheets of Bank/financial institutions and facilitates the later to concentrate on normal banking activities.
- Banks and financial institutions sell a large proportion of their bad loans or NPAs to ARCs, which recover them through attachment, liquidation, etc. ARCs can acquire the NPAs or bad loans of financial institutions or banks on their own account or through the issuance of Security Receipts to Qualified Institutional Buyers. This whole process is called ‘securitisation’ whereby loans of banks and financial institutions are converted into marketable securities through the issuance of security receipts.
- SARFAESI Act provides a legal framework for the securitization of financial assets and asset reconstruction, and the security receipts issued by ARCs are included in the definition of ‘securities’ under the Securities Contracts (Regulation) Act, 1956.
- Taxability of Securitized Debt Instruments and Security Receipts are governed by Section 115TCA read with Section 10(23DA) of the Income-tax Act whereby pass-through status has been provided to securitization trusts, that is, SPVs or trusts set up by ARCs. Thus, income arising to securitization trust is exempt from tax under section 10(23DA), while income accrued or received from the securitisation trust from activity of securitization shall be taxable in the hands of the investor under section 115TCA.
Non-Resident Taxation:
- Non-residents are generally exposed to double taxation due to tax liability in two or more countries.
- Countries have entered into Double Taxation Avoidance Agreements (DTAAs) with other countries to avoid double taxation of non-residents.
- The tax rate for non-residents may differ from that of residents, for example, dividends on shares are taxed at a higher rate for non-residents.
- To claim any relief under DTAAs, the non-resident will be required to obtain a Tax Residency Certificate (TRC) of the country of its residence.
- Non-resident Indian citizens or Persons of Indian Origin have an option to avail the provisions of chapter XII-A of the Income Tax Act which provide concessional rates of tax.
- Finance Act 2021 has introduced amendments to address the mismatch in taxation of income from notified overseas retirement fund.
