TAXATION – IMPACT OF NEW CLARIFICATIONS ON DDB & STRIPS
July 31, 2019
TAXATION – IMPACT OF NEW CLARIFICATIONS ON DDB & STRIPS
What will be the impact of new clarification with regard to tax treatment of income from Deep Discount Bonds and STRIPS ?
The CBDT had earlier clarified vide its Letter F. No.225/45/96-ITA dated 12-3-1996 ( reported in 88 Taxman 146) that in case of Deep Discount Bonds –
(a).The difference between the bid price (subscription price) and the redemption price (face value) of such bonds will be treated as interest income.
(b).On transfer of the bonds before maturity, the difference between the sale consideration and the cost of acquisition would be taxed as income from capital gains where the bonds were held as investment, and as business income where the bonds were held as trading assets.
(c).On final redemption, however, no capital gains will arise.
(d).Tax would be deducted at source on the difference between the bid price and the redemption price at the time of maturity.
2. Such tax treatment of Deep Discount Bonds, however, has posed the following problems according to the CBDT:
(i).Taxing the entire income received from such a bond in the year of redemption as interest income gives rise to a sudden and huge tax liability in one year whereas the value of the bond has been progressively increasing over the period of holding.
(ii) Where the bond is redeemed by a person other than the original subscriber, such person becomes taxable on the entire difference between the bid price and the redemption price as interest income, since he is not able to deduct his cost of acquisition from such income.
(iii) A company issuing such bonds and following the mercantile system of accounting may evolve a system for accounting of annual accrual of the liability in respect of such a bond and claim a deduction in its assessment for each year even though the corresponding income in the hands of the investor would be taxed only at the time of maturity.
(iv) Taxing the entire income only at time of maturity amounts to a tax deferral.
3. The CBDT has reviewed the tax treatment of income arising from Deep Discount Bonds in the above backdrop and has issued new clarification vide Circular No. 2/2002, dated 4-2-2002 [see page LU-240 of CAPJ, March, 2002 issue]. The relevant situations, as explained, are dealt hereinafter :
3.1 General Treatment
Every person holding a Deep Discount Bond will make a market valuation of the bond as on the 31st March of each Financial Year (hereafter referred to as the valuation date) and mark such bond to such market value in accordance with the guidelines issued by RBI for valuation of investments. For this purpose, market values of different instruments declared by the RBI or by the Primary Dealers Association of India jointly with the Fixed Income Money Market and Derivatives Association of India may be referred to.
(b) The difference between the market valuations as on two successive valuation dates will represent the accretion to the value of the bond during the relevant financial year and will be taxable as interest income (where the bonds are held as investments) or business income (where the bonds are held as trading assets).
(c) In a case where the bond is acquired during the year by an intermediate purchaser (a person who has acquired the bond by purchase during the term of the bond and not as original subscription) the difference between the market value as on the valuation date and the cost for which he acquired the bond, will be taxed as interest income or business income, as the case may be, and no capital gains will arise (in the hands of such purchaser) as there would be no transfer of the bond on the valuation date.
3.2 Transfer before maturity
Where the bond is transferred at any time before the maturity date, the difference between the sale price and the cost of the bond will be taxable as capital gains in the hands of an investor or as business income in the hands of a trader. For computing such gains, the cost of the bond will be taken to be the aggregate of the cost for which the bond was acquired by the transferor and the income, if any, already offered to tax by such transferor (in accordance with para 3.1(b) above) up to the date of transfer.
(b) Since the income chargeable in this case is only the accretion to the value of the bond over a specific period, for the purposes of computing capital gains, the period of holding in such cases will be reckoned from the date of purchase/subscription, or the last valuation date in respect of which the transferor has offered income to tax, whichever is later. Since such period would always be less than one year, the capital gains will be chargeable to tax as short-term capital gains.
Where the bond is redeemed by the original subscriber, the difference between the redemption price and the value as on the last valuation date immediately preceding the maturity date will be taxed as interest income in the case of investors, or business income in the case of traders.
(b) Where the bond is redeemed by an intermediate purchaser, the difference between the redemption price and the cost of the bond to such purchaser will be taxable as interest or business income, as the case may be. For this purpose, again, the cost of the bond will mean the aggregate of the cost at which the bonds were acquired and the income arising from the bond which has already been offered to tax by the person redeeming the bond.
Apart from original issue of Deep Discount Bonds, such bonds can also be created by “stripping”, i.e. the process of detaching the interest coupons from a normal coupon bearing bond and treating the different coupons and the stripped bond as separate instruments or securities (“strips”) capable of being traded independently. Such a mechanism, referred to as STRIPS (Separate Trading of Registered Interest and Principal of Securities) creates instruments which are in the nature of Deep Discount or Zero Coupon Bonds from out of the normal interest bearing bonds. Accordingly, the tax treatment of the different components of principal and interest created by such stripping will be on the same lines as clarified in the preceding paragraphs in respect of Deep Discount Bonds.
(b) The process of stripping of a normal interest-bearing bond into its various components will not amount to a transfer within the meaning of the Income-tax Act as it merely involves the conversion of the unstripped bond into the corresponding series of STRIPS. Similarly, the reconstitution of STRIPS to form a coupon bearing bond will not amount to a transfer.
3.5 Tax deduction at source
The difference between the bid price of a deep discount bond and its redemption price, which is actually paid at the time of maturity, will continue to be subject to tax deduction at source under section 193 of the Income-tax Act. Under the existing provisions of that section, no tax is deductible at source on interest payable on Government securities. Further, the Central Government is empowered to specify any such bonds issued by an institution, authority, public sector company or co-operative society by way of notification, exempting them from the requirement of TDS.
3.6 Option to investors
Considering the difficulties which might be faced by small non-corporate investors in determining market values under the RBI guidelines and computing income taxable in each year of holding, it has further been decided that such investors holding Deep Discount Bonds up to an aggregate face value of rupees one lakh may, at their option, continue to offer income for tax in accordance with the earlier clarifications issued by the Board referred to in para 1 above.
4. Confusions/Controversies still persisting in case of DDBs
The sea change in CBDT’s view only reflects ad-hocism in dealing with such important issues, which has bearing on large number of investors as well as other taxpayers. The following points need consideration :
Since Deep Discount Bond is also a capital asset and its redemption on maturity constitute transfer under section 2(47), therefore there is no reason why the difference between issue price and redemption value on maturity should not be treated as capital gains.
(b) It seems that while issuing the new clarifications, revenue collection at earliest point of time has been a guiding factor for the decision makers. It has been prescribed that income will be considered on accrual basis, i.e., difference in market value on two valuation dates. In case of deep discount bonds the interest is received by the holder at the time of maturity, thus one will have to pay tax every year, from his own funds. Tax payment in such cases may be difficult due to liquidity problem.
A more rationale approach could have been that the relevant Company should issue an advice intimating the amount of interest accrued in every financial year and such company should also be required to deduct TDS on such accrued interest. It may be mentioned that as per prevailing practice, interest accrued on NSC and KVP is also to be declared as income every year on the basis of the interest accruals as notified from time to time depending upon the fact as to in which year the investment was made. Such deemed reinvestment of interest on NSC is even entitled to rebate u/s 88.
(c) In the new clarification there is prejudice in as much as there is an inbuilt conclusion that for all investors, the gain will be short-term as the cost will be taken with reference to the last valuation date, i.e., 31st March. It is respectfully submitted that the guideline issued by the CBDT is erroneous, inconsistent with law and without jurisdiction. The gain being long-term or short-term has to be essentially determined as per the definition contained in section 2(29B) and 2(42B) of the Income-tax Act. Short-term capital asset has been defined in section 2(42A) as capital asset held by an assessee for not more than 36 months immediately preceding the date of its transfer. It has also been provided that in case of shares held in a company or any other listed security or units of UTI or a MF, the period reckoned for this purpose shall be 12 months instead of 36 months. A long-term capital asset has been defined in section 2(29A) as a capital asset which is not a short-term capital asset.
Likewise, date of acquisition has to be the real date of acquisition. Obviously, it has to be either the date of original subscription or the date of purchase in case of an intermediate purchaser. But the CBDT’s clarification states that for the purposes of computing capital gains, the period of holding in such cases will be reckoned from the date of purchase/subscription, or the last valuation date in respect of which the transferor has offered income to tax, whichever is later.
However, I would humbly submit that, the above clarification of the CBDT of deeming the last valuation date as date of acquisition is erroneous and based on misconception of law.
(d) The requirement of taking market value at the end of each financial year may disturb the basics of charging of income tax in case the assessee is following the cash system of accounting.
(e) The new circular is contradictory in its basic approach. At one hand it says that income will be considered every year and on the other hand it provides for the TDS on the whole amount of income at the time of redemption/maturity. It says – “The difference between the bid price of a deep discount bond and its redemption price, which is actually paid at the time of maturity, will continue to be subject to tax deduction at source under section 193 of the Income-tax Act.”
There is no logic behind such clarification.
(f) Whether the new Circular will apply to the Bonds issued previously, is also a matter of controversy. However, in all fairness, the new guidelines should be applied only to the Bonds issued on or after the date of new Circular. It is also submitted that the earlier guidelines in the year 1996 were issued after careful consideration and based on that the investors had decided to invest. Thus giving retrospective effect to the new Circular is not desirable.
(g) It is strange that instead of following the uniform practice, the CBDT has adopted the policy of pick and choose in allowing option to the investors holding Deep Discount Bonds upto an aggregate face value of rupees one lakh.
Such clarifications will only add to prevailing confusion, thus a long-term solution needs to be worked out by the CBDT. It may also be mentioned that Circulars should be consistent with law. Further the Circulars beneficial to the taxpayers will only be binding on them and not the Circulars which are inconsistent with law and prejudicial to the interest of the taxpayers. However Circulars being binding on the AO, its implementation may prove to be a nightmare for the taxpayers.