Smart guys make 'dirty' gains on tax-free bonds

Investors take advantage of cum-interest pricing on bourses to save more tax

Some smart investors are taking advantage of ‘dirty’ pricing available on exchanges to amplify their returns on the tax-free bonds. This activity is rampant in the bonds issued in the last financial year, said dealers and bank officials. Last year, the government had allowed stae-owned infrastructure firms NHAI, IRFC, HUDCO, REC and PFC to issue tax-free bonds. These companies raised around Rs 20,000 crore with coupon rates ranging between 8.1% to 8.3%. Interest income on these bonds, designed to encourage long- term investment in infrastructure and announced by the finance minister in his budget speech, are exempt from tax.  But, the capital gains made on selling the bonds in the secondary market are taxable.

These bonds are tradeable in the secondary market both over the counter (OTC ) and on exchange platforms. The exchange platform quotes and trades these bonds on a ‘dirty price’ basis. “Dirty price" (or cum-interest price) includes the accrued or accumulated interest from the last interest payment date to the date of the transaction. A price that does not include the accumulated interest is called "clean price". 

“Investors are showing both the premium on bonds and the accrued interest on these bonds as tax-free income. This has become a grey area,” said a senior treasury official from a private bank.  “Exchanges must clearly show yield on the bonds separately, if they are putting up the dirty prices or put up clean prices as put up by the FIMMDA platform.” FIMMDA stands for Fixed Income Money Market and Derivatives Association of India. OTC trades are reported on a platform run by the association.

Investors are taking advantage of the fact that for trades in the equity segment of the exchanges, the contract note shows a single price which includes both accrued interest and price premium. “There is lot of ambiguity and some retail investors are taking advantage of this,” said Dheeraj Nigam, vice president, Bajaj capital. “As per tax law, any premium on sale of these bonds within 365 days of purchase is added to the gross income and taxed at rates applicable to the individual. By showing the entire proceeds as income from tax-free bonds, they are escaping tax payable on the premium,” Nigam said.  The Exchanges and the regulator have received suggestions from the market participants to plug the loophole by making the pricing mechanism more transparent, officials said. 

This year too, Rural Electrification Corp, Power Finance Corp, IIFCL, Hudco, NHAI, NHB and IRFC plan to raise at least Rs 50,000 crore in all, by issuing tax free bonds by March.