Deep Discount Bonds are variously known as Zero Coupon Bonds or Money Multiplier Bonds, depending upon the issuing company. However, the structure remains the same, notwithstanding the name.
The term 'Zero Coupon' arises as these bonds are cumulative in nature and do not give any interest during their tenure.
Such bonds were extremely popular with investors who did not need a regular stream of interest income and were looking to keep away something for a rainy day.
The bad news is that a circular issued a couple of years ago (Circular 2/2002 [F.No. 149/235/2001-TPL] dated February 15, 2002) changed the tax treatment of these bonds drastically.
After investors protested against the practical difficulties caused by the new diktat, a new circular has been issued (Circular No. 4/2004 dated May 13, 2004) apparently in a bid to provide succour. However, unfortunately the new rules also fall short of providing a practical solution to the problem.
Let us first begin with examining how originally the taxation of DDBs stood. The difference between the issue price and the redemption price of DDBs was treated as interest income.
On transfer of bonds before maturity, the difference between the sale consideration and issue price was to be treated as capital gains/loss if the investor purchased them by way of investment.
Admittedly, this tax structure was not too kind to any assessee. He was denied the capital gains benefit and was made to consider the difference between the lump sum payment at redemption and the original capital as interest.
It was more unfair to the holder in due course (person buying the bonds in the secondary market), as he was subjected to tax on the difference between the redemption and issue price as interest, as if he was the original investor.
If this was harsh and unreasonable, the amendment (vide the first circular) was worse.
The amendment
Each investor now had to make a market valuation of the DDB as on March 31 of each year (called the valuation date) and mark such bond to such market value in accordance with the guidelines issued by the RBI.
The tax structure
The difference between the market valuations as on two successive valuation dates represented the accretion to the value of the bond during the relevant year and was taxable as interest or business income, as the case may be. In other words, an investor has to pay tax every year on income that he has not received!
No capital gains arose as there was no transfer of the bond on the valuation date.
Where the bond was transferred at any time before maturity, the difference between the sale price and the cost of the bond was to be taxed 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 the sum of the cost for which the bond was acquired for and the income (interest accrued) on which tax has already been paid.
Option to investors
The notification went on to say that as a consideration for the difficulties which might be faced by small investors in determining market values under the RBI guidelines and computing income taxable in each year of holding, those holding DDBs up to an aggregate face value of Rs 1,00,000 may, at their option, continue the erstwhile tax treatment for the bonds.
CBDT had subsequently clarified that this mode of calculation will not be applicable to existing bondholders. Only bonds issued after February '02 will be under the purview of new legislation.
Tax deduction at source: The final nail
As if this much was not enough to effectively kill the instrument, it was also specified that as the income on the bonds at the time of redemption is to be taxed as interest income, normal provisions of tax deducted at source or TDS will apply before distributing the income.
What CBDT possibly did not foresee was that this last provision regarding TDS would result in a (perhaps unintended) situation of double taxation.
As already explained above, an investor holding DDBs would pay tax on the difference between the value of the bonds on the two valuation dates. This increase in the value would be taxed as interest income.
The issuing company has nothing to do with this tax, it is paid by the investor and reflected in his tax return. In other words, the investor does not have any proof by way of a TDS certificate or some such supporting document issued by the company.
Now, at the end of term of the bonds, the issuing company would also deduct tax at source on the entire interest income from the day of investment. This, even when tax has been paid by the investor each year.
Hitherto, the investor had no way out of the problem, apart from filing returns and asking for a refund.
The new circular
Circular No. 4/2004 basically reiterates that indeed TDS has to be applied on the entire amount. However, the investor may make an application under Section 197 of the ITA, requesting the Assessing Officer to issue a certificate for no deduction of tax or deduction at a lower rate.
For doing this, the investor should furnish, along with the prescribed Form No. 13, details of the income offered for tax by him from year to year.
In case the investor was not the original subscriber, and had acquired the bonds from some other person, he should furnish the relevant particulars including the name, address and PAN of such other person.
If the Assessing Officer is satisfied that the applicant assessee, has declared his income from the bonds from year to year on accrual basis during the period the bonds were held by him, he shall issue a certificate allowing the tax deduction at source at such reduced rate as is justified by the total income of the applicant in the year of redemption.
Lip Service Again?
First of all, for a holder in due course, the new circular is close to ludicrous. How is it possible to run after the seller, especially if a substantial amount of time has elapsed between the purchase and the sale?
And even if the seller is tracked down, will he part with the required personal information, that too to be provided to the Tax Department?
Coming to the original investors. Making an application to the Income-Tax officer itself proves to be a hurdle. Perhaps the services of a chartered accountant will be needed making it unaffordable for persons with limited means. And then too, how many assessing officers would be "satisfied" in time, before the issuing company deducts the tax.
Possible solution
It is suggested that instead of Section 197, the TDS procedure should have been included under the ambit of Section 197A (by making the necessary modifications), where the investors submit Forms 15G or 15H (for senior citizens) directly to the issuing company. Not only is this process simpler, it is familiar and understood by all.
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