Section 2(48) Income Tax: Zero Coupon Bonds – Meaning & Tax Treatment

No/ Zero interest is payable while the investor holds the Zero Coupon Bonds, which is sold at a discounted price as compared to the final maturity value. Such discount actually represents the interest income of the investor over the holding period.

Definition of ‘Zero Coupon Bond’: Section 2(48) Income Tax

As per Section 2(48) of Income Tax Act, 1961, unless the context otherwise requires, the term  “zero coupon bond” means a bond-

(a) issued by any infrastructure capital company or infrastructure capital fund or infrastructure debt fund or public sector company or scheduled bank on or after the 1st day of June, 2005;

(b) in respect of which no payment and benefit is received or receivable before maturity or redemption from infrastructure capital company or infrastructure capital fund or infrastructure debt fund or public sector company or scheduled bank; and

(c) which the Central Government may, by notification in the Official Gazette, specify in this behalf.

Explanation 1.- For the purposes of this clause, the expression “scheduled bank” shall have the meaning assigned to it in clause (ii) of the Explanation to sub-clause (c) of clause (viia) of sub-section (1) of section 36.

Explanation 2.- For the purposes of this clause, the expression “infrastructure debt fund” shall mean the infrastructure debt fund notified by the Central Government in the Official Gazette under clause (47) of section 10.

“Scheduled Bank” means the State Bank of India constituted under the State Bank of India Act, 1955 (23 of 1955), a subsidiary bank as defined in the State Bank of India (Subsidiary Banks) Act, 1959 (38 of 1959), a corresponding new bank constituted under section 3 of the Banking Companies (Acquisition and Transfer of Undertakings) Act, 1970 (5 of 1970), or under section 3 of the Banking Companies (Acquisition and Transfer of Undertakings) Act, 1980 (40 of 1980), or any other bank being a bank included in the Second Schedule to the Reserve Bank of India Act, 1934 (2 of 1934).

Tax Treatment of Zero Coupon Bonds

In the case of zero coupon bonds, the investor doesn’t get any regular coupon benefits during its tenure, i.e. no interest payments or benefits are received or receivable under the instrument before the date of maturity or the date of redemption. In such circumstances, what tax treatments are available for concerned parties, i.e. the investor and the issuer, during the holding period vis-a-vis the zero coupon bonds.

i) Taxation as Capital Gains/ Business Income in the hands of Investors

If zero coupon bonds is held as capital asset, income from transfer thereof shall be taxed under the head ‘income from capital gains’ whereas if the same is held as stock-in-trade, income from transfer thereof shall be taxed under the head ‘Profits and gains from business or profession’. Thus, no income from a zero coupon bonds shall be taxed on accrual basis during the period of its holding by a person unless there is a transfer of zero coupon bonds due to redemption, maturity or otherwise.

Maturity, redemption or otherwise transfer of zero coupon bonds shall be treated as transfer in the hands of investor for the purpose of capital gains tax under Section 2(47)(iva). Income arising from zero coupon bonds as defined in Section (48)(2) shall be taxed only in the year in which same is transferred or redeemed or matured.

Tax liability of investor on transfer of zero coupon bonds may be either short term or long depending upon the holding period, i.e. for not more than 12 months or otherwise.

Proviso to Section 112(1) of Income Tax clarifies the process of calculating tax on long term capital gains arising from transfer of zero coupon bonds. In such cases where the tax payable in respect of long-term capital gain arising from transfer of a zero coupon bonds exceeds ten per cent, of the amount of capital gains without indexing (i.e., before giving effect to the provisions of second proviso to section 48), then such excess shall be ignored.

ii) Pro-rata Discount Deduction for Issuer Company/ Fund

Section 36(iiia) of Income Tax provides that the fund or company which issues the zero coupon bonds shall be allowed a deduction for the pro-rata amount of discount, having regard to the life of such zero coupon bond, in the manner as may be prescribed.

It may be noted that IT Rule 8C prescribes the manner in which pro rata discount amount in respect of a zero coupon bond is to be calculated, as under:

(a) the period of life of the bond shall be converted into number of calendar months and, for this purpose, where the calendar month in which the bond is issued or the bond matures or is redeemed contains a part of a calendar month then, if such part is fifteen days or more than fifteen days, it shall be increased to one calendar month and if such part is less than fifteen days it shall be ignored;

(b) the amount of discount shall be divided by the number of calendar months determined in accordance with clause (a);

(c) where one or more than one calendar month out of calendar months determined in accordance with clause (a) is or are included in a previous year, the amount determined in accordance with clause (b) shall be multiplied by the number of calendar months so included and the amount so arrived at shall be taken to be the pro rata amount of discount for that previous year.

For the purposes of allowing pro-rata deduction to the issuer company:

(i) “discount” means the difference between the amount received or receivable by the infrastructure capital company or infrastructure capital fund or public sector company or scheduled bank issuing the bonds and the amount payable by such company or fund or public sector company or scheduled bank on maturity or redemption of such bonds;

(ii) “period of life of the bonds” means the period commencing from the date of issue of the bonds and ending on the date of the maturity or redemption of such bonds;

iii) TDS Not Applicable on Maturity/ Redemption

TDS is not applicable on income or maturity/ redemption proceeds of zero coupon bonds, in view of specific provisions of Section 194A(3)(x). In fact, Section 194A has been amended so that no TDS is deducted on income payable on zero coupon bonds.