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What is the difference between tax free bonds and tax saving bonds?

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10 Feb 20206 mins readBy MOFSL

It is quite common to use the terms tax-free bonds and tax saving bonds interchangeably. Actually, they are quite different. The difference lies in the way the tax treatment is imputed to the bonds. The government normally provides tax incentives on bonds to encourage investors into long gestation infrastructure projects. Hence there are tax benefits on long gestation infrastructure projects of institutions like REC, PFC, and IRFC etc. The idea is to use these tax breaks to encourage more investors to participate in these bonds and help finance the infrastructure needs of India. Let us first understand tax free bonds vs tax saving bonds. Also let us look at tax free bonds vs taxable bonds. Let us also look at the taxation of bonds in India and how the tax breaks changes the economics of these bonds..

Tax-free bonds - How they compare with taxable bonds
Tax-free bonds are those where the income received at regular intervals (interest) is entirely tax-free in the hands of the investors. Typically, these bonds are issued by entities that are backed by the government and therefore the default risk is almost zero. Typically, these bonds have long gestation period of 10, 15 or 20 years so you must invest in tax-free bonds only if you can afford to lock-in your funds for very long periods. There is no upper limit on investment in these bonds and hence HNIs and institutions find these bonds quite attractive.

The advantage of Tax-free bonds is that any income generated by way of interest on these bonds is entirely exempt in the hands of the investor under Section 10 (15) of the Income Tax Act. There are 2 more things to remember about tax-free bonds. Firstly, these bonds can be held in physical form or in demat form as part of your regular demat account. Secondly, the tax free interest is the only tax benefit on tax-free bonds. There is no other tax benefit available. Since the interest on these bonds is entirely tax-free in the hands of the investors, there is no deduction of TDS on the interest payable on these tax-free bonds. Here is how the economics of the tax-free bond looks like..
 

Bond ParticularsNormal Taxable BondTax-free BondDate of Bond issueJan 01st 2018Jan 01st 2018Face value of the bondRs.100,000Rs.100,000Annual Coupon payable8%6.5%Annual interest payableRs.8,000Rs.6,500Tax bracket 30% plus 4% surcharge31.2%NilTax paidRs.2,496NilPost Tax Interest Coupon5,5046,500Post tax yield (%)5.504%6.50%


As can be seen from the above illustration, the tax-free bond pays a coupon rate that is 150 basis points lower than the taxable bond. But when the impact of tax at 31.2% is considered at the peak rate, the tax-free bond actually earns nearly 100 basis points more in post tax terms. That is what makes tax-free bonds more attractive. Of course, the caveat is that you are prepared for a long gestation.

Tax-Saving Bonds - How they are different from tax-free bonds
While tax-free bonds make the interest tax free, tax saving bonds give you tax benefits for the investment amount. Remember, in case of tax-saving bonds the interest that is paid is fully taxable in the hands of the investor. There are broadly 2 types of tax-saving bonds..

1.  Tax Saving Bonds under Section 80CCF of the Income Tax Act
This was a special addition to Section 80C that provided an additional benefit of Rs.20,000 in the form of exemption in case of investment in infrastructure bonds. Assuming that you are in the peak bracket of 31.2% tax, an investment of Rs.20,000 in these Section 80CCF bonds will entitle you to a tax rebate of Rs.6240 (31.2% of Rs.20,000). Therefore your effective investment in the first year will be only Rs.13,760 and this will substantially enhance your effective yield. However, these Section 80CCF bonds were discontinued effective the AY 2012-13 and are not issued any longer.

2.  Capital Gains exemption bonds under Section 54EC
Under Section 54EC, your long term capital gains arising from assets other than from shares and securities can be reinvested in specified Section 54EC bonds issued by infrastructure companies. If your capital gains are entirely invested in these Section 54EC bonds then the entire capital gains becomes tax free in your hands. However, it needs to be remembered that these investments in Section 54EC bonds will be subject to a lock in of 3 years and any breach of this lock-in will mean that you lose your capital gains tax exemption already claimed. Such investment in Section 54EC bonds will have to be made within 6 months of the generation of capital gains.

So while tax-free bonds offer tax-free interest, tax saving bonds offers you special exemptions for investment!

 

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Disclaimer: The stocks, companies, or financial instruments mentioned in this blog are for informational purposes only and should not be considered as investment recommendations. It is advised to consult with your financial advisor before making any investment decisions. Investment in securities markets are subject to market risks, read all the related documents carefully before investing. Investors are strongly encouraged to carefully read the risk disclosure documents prior to participating in market-related investments or trading activities. Due to the volatile nature of financial markets, no guarantees can be made regarding investment returns. Motilal Oswal Financial Services Ltd. does not offer any assured returns on market-linked securities. Please note that past performance of stocks or indices is not indicative of future results.
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