The Hindu Business Line : The zero coupon bond — New provisions cut borrowing cost

THERE have always been long debates about the propriety of levying capital gains tax on business transactions. The Income-Tax Act has been grappling with this problem, sometimes levying the tax and sometimes dropping it. This is true of other countries also. The Table illustrates the confusion in this regard.

The levy of capital gains tax assumes special importance in dealings in the financial market. Different treatment is meted out to equity shares and bonds. There had been some confusion with regard to the levy of tax on bond yields.

The Central Board of Direct Taxes was not able to make up its mind on taxing the yield from zero coupon bonds. Two circulars were issued — one in 1996 and the second in 2002 — in this regard. The Kelkar Task Force noted that the clarifications resulted in discriminatory treatment of gains from zero coupon bonds as compared to the tax treatment of conventional bonds resulting in a preference in favour of the regular-return, conventional bond.

In order to correct the distortions in the tax treatment of ZCBs, the Kelkar panel recommended the following steps:

All gains from ZCBs listed in the market to be treated as capital gains and taxed accordingly, depending on the holding period.

All ZCB issues to be dematerialised.

Make it mandatory for all investors in ZCBs to quote PAN.

Amount paid on maturity of ZCBs to be exempted from TDS.

The definition

Section 2(48) of the Income-Tax Act 1961 has now been amended (will take effect from June 1, 2005) and a new definition of the term `zero coupon' has been provided. As per this definition, if a zero-coupon bond

"Is issued by any infrastructure capital company or infrastructure capital fund or public sector companion on or after the 1st day of June, 2005, "infrastructure capital company" and "infrastructure capital fund" shall have the same meanings respectively assigned to them in clauses (a) and (b) of Explanation 1 to Clause (23G) of Section 10;

No payment and benefit will be received or is receivable before maturity or redemption from the infrastructure capital company or infrastructure capital fund or public sector company;

Treatment in issuer's hands

The Finance Bill, 2005 proposes to insert a new Clause (iiia) in Section 36 (1) of the Act, According to the proposed Clause (iiia), the pro rata amount of discount on a zero coupon bond having regard to the period of life of such bond calculated in the manner as may be prescribed, shall be allowed as a deduction in the hands of the issuer — the infrastructure capital company or infrastructure capital fund or public sector company issuing the bond.

"Discount" means the difference between the amount received or receivable by the infrastructure capital company or infrastructure capital fund or public sector company issuing the bond and the amount payable by such company or fund or public sector company on maturity or redemption of such bond. "Period of the life of the bond" means the period commencing from the date of issue of the bond and ending on the date of maturity or redemption of such bond.

Tax the investor has to pay

Ending all controversy, the Finance Bill, 2005 amends the definition of `Transfer' in Section 2 (47) by inserting a new sub-clause (iv-a). The result will be that the proceeds on maturity or redemption on ZCB will be treated as a transfer, and the returns will be taxed as long-term or short-term capital gains, depending on the period of holding.

LTG will be taxed at 20 per cent, with indexation benefit and 10 per cent without indexation. A question arises whether the Finance Ministry has overlooked the 3rd proviso to Section 48, which bars indexation benefit to any bonds other than capital index bonds issued by the Government.

These provisions are welcome as they reduce the cost of borrowing. Probably the benefits can be extended to the private sector also on the same terms that the public sector company is enabled to issue the ZCB. It is also necessary that the rules to be prescribed should be helpful and take care of the probable inflation indexed bonds that may be issued at a later date.

(The author is a former Chief-Commissioner of Income-Tax.)

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