What are tax saving bonds and how do they work?

Posted by aarav badhe on February 15th, 2020

Bonds are a way for companies to raise funds from investors. Simply put, a bond is a sign of indebtedness between the borrower and the lender. Some of the common bonds are municipal bonds and corporate bonds. The Central and State Governments also raise funds through bonds. These funds are repaid when the bond matures. To compensate the investor for putting capital, interest is paid out on these bonds. The interest becomes the cost of financing for the company and income for the investor.

Some bonds can be traded on the stock exchange whereas others cannot be traded till their maturity. These GOI bonds and other bonds pay interest to the investors in exchange for the funds raised. Generally, the interest income from these bonds is taxable at slab rates for individuals and at a flat rate for other assessee.

Some tax-free bonds provide income exemption i.e. the interest income earned on these bonds is exempt from tax. However, they do not provide any other benefit for making any investment in the bonds. These tax-free bonds India are generally issued by National Highways Association of India (NHAI), Rural Electrification Corporation (REC), Power Finance Corporation (PFC) etc. However, the interest income is exempt from income tax. The interest does not increase the taxable income of the individual. Depending on the income tax slab of the individual, the pre tax return for these bonds increases. The interest income is exempt under Section 10(15) of the Income Tax Act.

Apart from this, there is one category of tax saving bonds which operate differently as compared to tax free bonds. In case of tax saving bonds, they give a benefit to the investor for making an investment in these bonds. This benefit is governed by Section 80CCF of the Income Tax Act. Under Section 80CCF, a deduction of Rs. 20,000 is given to individuals who make investments in tax saving bonds. This deduction is given over and above the deduction under Section 80C to Section 80CCD of Rs. 1,50,000. This helps the individual to save tax on making this investment.

However, there are a few things to remember while making such investments. These bonds have a lock in period of 5 years. This means no redemption is possible before this time. This reduces the liquidity on the instrument.

Another thing to remember is that these tax saving bonds only provide a deduction for making an investment in the bonds. But the actual interest income is taxable as per the slab of the investor. In that sense, this is like Senior Citizen Savings Scheme or National Savings Certificate. Both these instruments give a tax deduction for investment made under Section 80C. But the interest income is taxable at regular slab rates.

There are a few conditions to avail benefit on such tax saving bonds:

1.    The benefit is only available to an individual investor or a Hindu Undivided Family (HUF) that makes an investment.
2.    Even if investment is made jointly, the first holder is the only one who can avail benefits under Section 80CCF.
3.    The maximum deduction available under this section is Rs. 20,000. If an amount less than Rs. 20,000 is invested, then the lower amount will get a deduction.