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Inflation Indexed Bonds: Tax Treatment

Published on Wed, Jun 12 18:09, Updated at Wed, Jun 12 at 19:49
Source :  

By: Sunil Gidwani, ED & Sneha Bhagat, Manager, PwC India

This much talked about financial instrument was issued by the Reserve Bank of India (RBI) on 4 June, 2013. This was an outcome of the Budget speech by the Finance Minister who indicated that instruments that will protect savings from inflation, especially the savings of the poor and middle classes will be introduced.  The current issue was restricted to institutional investors and was benchmarked to Wholesale Price Index (WPI). A separate tranche linked to Consumer Price index (CPI) would be launched once CPI is stabilized. On the institutional offering, though the yield of 1.44% turned out to be lower than the market expectations of around 1.7%, the 10 year IIB issue was over-subscribed.

The way IIB works is that the investor will invest a fixed sum of money (i.e. principal) which will be adjusted to inflation at year end and the investor will be paid fixed percentage of coupon on this adjusted higher principal amount. Thus, the IIBs safeguard the principal and interest from inflation. The earlier issue of capital indexed bonds of 1997 protected only the principal amount and not the interest. In case of upward trend in inflation, this higher principal amount will be repaid at the end of the bond life whereas in case of lower inflation trends, which seem unlikely, the investor will be repaid at least the original principal amount. Thus, the principal will be protected at all times. For example, if the principal is Rs 100 and the inflation is 5%, then at the year end, coupon of 1.44% would be calculated on Rs 105, and so on for subsequent years. On redemption after 10 years, the inflation adjusted principal amount would be repaid to the investor. 

The RBI has offered the first lot of IIBs at a real yield of 1.44%. As an investor, one will compare this with the yield offered by regular interest bearing securities issued by the RBI. Currently the coupon offered by Government securities is approx 8.09% with similar maturities. In case of inflation rate higher than the break-even rate, IIBs would prove to be more beneficial.

There are no special tax concessions or treatment provided to IIBs as per the current tax regime. A summary of applicable tax rates for investment in Government securities is provided below (without considering surcharge and cess):


Long term capital gains

Short term capital gains


Domestic Institutional Investors




Foreign Institutional Investors ("FII")










*Depending on whether inflation adjustment for the cost of purchase is applied or not.
**Applicable to interest received on or after June 1, 2013 but before June 1, 2015. In any other case, the interest shall be chargeable at the rate of 20%.

In case of IIBs, the fixed coupon paid to investors should obviously be regarded as 'interest income' and taxed at rates mentioned above. The excess of inflation adjusted principal over the original issue price would be in the nature of premium on redemption and as such should be taxed as 'capital gains'. Also, if the investors sell the bond in the secondary market before maturity, difference between the sale and the purchase price would be taxed as 'capital gains'.  In case of IIBs, there will be a relatively lower income offered as 'interest' and a larger portion as 'capital gains.
Thus, when one compares IIBs with regular Government securities, in case of the former a larger portion of income is likely to be treated as capital gains, whereas in case of latter there would be larger interest income. Hence, the tax impact would depend on the rates of tax mentioned above.  For FIIs investing from a favourable tax jurisdiction say France, Cyprus, Ireland, Netherlands, Mauritius, etc. capital gains earned from the IIBs will be exempt under the respective tax treaty. Also, the interest income earned by the FIIs will be taxed at the lower rate of 5%. Thus, the tax treatment for the FIIs is more favourable as compared to other investors.

In case of corporate bonds, there have been concerns that if the coupon is very low compared to market rates, then premium on redemption of such bonds may effectively take the character of interest and accordingly the tax treatment may follow. This is because in case of corporate bonds, the pre-agreed return could be disguised by the parties as premium. However, going by the structure of IIBs, it may not be proper to compare them with low interest bearing corporate bonds since the so called 'premium' to be paid on maturity or redemption is neither certain nor determinable upfront. Hence the character of gains on redemption should stay as capital gains. 

Interestingly, as regards availability of inflation adjustment for cost of purchase while calculating long term capital gains, when capital indexed bonds were introduced in 1997 (which never really took off), the tax laws specifically provided that the inflation adjustment based on notified factors would be available for such bonds. So for example, if the cost of purchase was 100, and inflation adjustment factors notified for tax purposes is say 8%, then the cost of purchase is recalculated as 108 which is deducted from sale price/redemption to arrive at taxable capital gains. If principal repayment for capital indexed bonds is adjusted for inflation, effectively there would be no taxable capital gains if the inflation factors used were same for both the purposes (though for tax purposes, the law provided for CPI whereas for arriving at principal repayable WPI be used as the basis). No such tax benefit has been provided for in case of IIBs.

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