Bonds are often marketed on their coupon rate or yield, but the return that actually lands in your bank account depends heavily on taxation. Two different types of income arise from bonds, and each is taxed differently. Here’s how it works.
Different Kinds of Income From Bonds
When you invest in a bond, you can earn money in two ways:
- Interest income — the periodic coupon payments you receive while holding the bond.
- Capital gains — the profit (or loss) you make if you sell the bond anytime before maturity, or if you buy it at a discount and redeem it at face value.
Each is taxed under a different set of rules.
Taxation of Interest Income
Interest earned on bonds is added to your total income and taxed under “Income from Other Sources,” at your applicable income tax slab rate. There’s no special concessional rate for interest income the way there sometimes is for capital gains.
TDS (Tax Deducted at Source): Under Section 193 of the Income Tax Act, TDS may apply on interest paid on bonds/debentures. However, interest on listed bonds and debentures held in dematerialised form is generally exempt from TDS, regardless of amount. For bonds held in physical form, TDS is typically deducted once interest crosses a specified threshold in a financial year. Even where no TDS is deducted, the interest is still fully taxable in your hands and must be reported.
Tax-free bonds are the exception: Certain government bonds (issued in the past by entities like NHAI, PFC, IRFC, REC) carry interest that is exempt from tax under Section 10(15) of the Income Tax Act. These are labelled “tax-free bonds” specifically because of this feature; it does not apply to ordinary corporate bonds or NCDs.
Taxation of Capital Gains on Bonds
This is where it gets more nuanced, because the rules depend on whether the bond is a listed bond or an unlisted bond, and how long you held it.
Listed Bonds/Debentures
- Held for more than 12 months: treated as long-term capital gains (LTCG).
- Held for 12 months or less: treated as short-term capital gains (STCG), taxed at your slab rate.
Unlisted Bonds/Debentures
- Held for more than 36 months: treated as long-term capital gains (LTCG).
- Held for 36 months or less: treated as short-term capital gains, taxed at your slab rate.
Following the Finance Act 2023 and subsequent amendments, the tax treatment of capital gains on debt instruments has changed significantly compared to the older regime, including the removal of indexation benefits for many categories of debt investments.
Because the rates, holding periods, and indexation rules for capital gains have seen frequent revisions in recent Union Budgets, the exact applicable rate at the time you sell can differ from what applied when you bought the bond. This is one area where checking the current, official provisions (or asking a chartered accountant) before filing your return is genuinely important; don’t rely solely on rules that applied in an earlier financial year.
Special Cases Worth Knowing
Zero-coupon bonds: Since these don’t pay periodic interest, your entire return comes as the difference between purchase price and redemption/sale value, taxed as a capital gain rather than as interest income. Certain zero-coupon bonds specifically notified under Section 2(48) of the Income Tax Act get treated as long-term capital assets regardless of the general listed/unlisted holding period rules, subject to conditions.
Sovereign Gold Bonds (SGBs): Interest earned (currently a fixed annual rate paid on the issue price) is taxable as “Income from Other Sources.” However, capital gains arising on redemption at maturity by an individual are exempt from tax, a feature unique to SGBs. If sold before maturity on the exchange, normal capital gains rules apply instead.
Sale before maturity vs. holding to maturity: If you hold a bond until it matures and simply get your face value back, that’s usually treated as redemption, not a “sale”; the tax treatment can differ from a market sale before maturity. It’s worth understanding which scenario applies to your specific bond.
Setting Off Capital Losses: If you sell a bond at a loss, that capital loss can typically be set off against capital gains from other investments (subject to the usual short-term/long-term matching rules under the Income Tax Act) and carried forward for a limited number of assessment years if not fully used.
Reporting Requirements: Even when TDS isn’t deducted, all bond interest and capital gains must be disclosed in your income tax return under the appropriate schedules. Keep your contract notes, interest certificates, and Form 26AS/AIS handy at tax filing time to reconcile what’s been reported to the tax department.
FAQs
Do I need to pay tax on bond interest if TDS wasn’t deducted?
Yes. TDS and taxability are separate things. Interest is taxable in your hands regardless of whether tax was deducted at source.
Is interest from all government bonds tax-free?
No, only specific bonds notified as “tax-free bonds” under Section 10(15) carry this benefit. Regular government securities (G-Secs) and most PSU bonds are fully taxable.
How is the holding period calculated?
Generally from the date of purchase (or allotment) to the date of sale or redemption. For bonds bought in tranches, each tranche’s holding period is tracked separately.
Should I consult a tax professional?
Given how often capital gains rules for debt instruments have changed in recent years, yes, especially for larger investments or non-standard instruments like zero-coupon or unlisted bonds.
Photo by Nataliya Vaitkevich from Pexels (Free for Commercial use)
Photo published on February 18th, 2021
