From the Dilbert folder – differential taxation of bond income

When government bond yields moved up to 8% last month, besides public sector banks (PSBs), retail investors were missing from the market. While the absence of PSBs raised eyebrows, there was no surprise around the lack of direct retail participation. That is the sad reality of Indian debt markets – our tax regime for bonds has ensured that direct retail participation will continue to be minimal, even if levels look attractive for savers.

There are some policies that seem anomalous, and yet survive without change year after year. I save such cases in a folder named “Dilbert”, after Scott Adam’s satirical cartoon strip. One item in this folder is our differential taxation policy for bonds, within the larger issue around taxation of savings. 

Taxation of savings

The larger issue of taxation of savings probably has enough material to fill a whole Dilbert volume. Ask our RBI Governor, who chafed about the high and multiple layers of tax on capital and investments. Also, the choice of where we deploy our savings across fixed deposits, bonds, equities, funds, insurance, etc. is dictated at least as much by tax considerations, as by risk-reward assessments. North Block determines these asset level incentives, moral hazard be damned. 

One is afraid to ask for a uniformly low capital taxation policy across asset classes, because we could instead be saddled with a uniformly high tax regime. The introduction of LTCG on equities in this budget reinforces this fear. 

Taxation of savings is an involved issue that needs informed debate. For now, let’s focus on a subset – differential taxation of bonds.

The issue of bond taxation

The taxes we pay on bonds depend on whether we hold them directly, or through a fund. This is different from equities, where the tax treatment is largely uniform irrespective of the mode of holding.

If we held bonds directly, the coupons we receive are taxed at our own marginal tax rate. If our total annual income were over Rs. 10 lakh, coupons would be taxed at 30% plus surcharges. In addition, if we sold a listed bond after a year and booked capital gains, we would pay an additional 10% on these gains.

On the other hand, if we invested through a debt fund under growth option, the fund would reinvest the coupons and give us capital gains on exit. If we stayed invested in the fund for over three years, we would show all income as long-term capital gains, take the benefit of inflation indexation, and the net gains would then be taxed at 20%. That can be seriously more advantageous than paying 30% plus surcharges on gross coupons. 

Why retailing of bonds is difficult

Authorities often call in primary dealers to discuss why retailing of government securities hardly happens in India. These are farcical meetings – if one asked for a show of hands of how many people in the room directly owned bonds themselves, we would draw a blank!

The core issue, of course, is differential taxation. Last month, when illiquid government bonds yielded 8.0%, they looked attractive as an avenue for savings. However, the post tax return of directly owning the bonds at the highest tax slab would drop to 5.25%. It made much more sense to put money in a debt fund instead, enjoy the tax advantage, rather than buy and hold the bond directly. 

This is an obvious reason why retail investors aren’t major direct players in bonds. Otherwise, as an asset class with low credit risk and high liquidity, government bonds are a natural savers' asset class.  

The policy question

Why should we pay higher tax for a direct bond investment, compared to holding the same asset through a fund? After all, in equities, there is no such difference between direct and fund holdings. 

This isn’t questioning the value of fund managers. They track markets better than the average investor, and have provided superior returns over time. That is why equity funds do not need the crutches of a differential tax regime to bring in ample retail flows.

But in the case of lower risk bond investments, investors really have no choice. As long as they pay income taxes, they are forced to invest through a bond fund and pay AMC fees, rather than directly own a bond – even to maturity. AMCs earn a fee on account of this tax regime, and not because of the promise of better returns alone. This does not sound right.

And a possible solution

So what could be a possible solution set? First, the tax treatment for any asset class should be indifferent to the mode of holding – direct or through a fund. Second, we CANNOT raise taxes on debt funds to levels similar to direct bond holdings – that would make debt savings unattractive, raise interest rates, and move investors away from financial savings. Instead, taxation of direct bond investments should be lowered to that of debt funds. In fact, there is a case to reduce taxes across debt investments even further, and bring them closer to equity levels. Third, specific to bonds and fixed deposits, this means that coupons (and by extension, interest on fixed deposits) should get the benefit of inflation indexation. Fourth, rather than incentivize creative schemes that convert coupon flows to capital gains, we should have a uniform (low!) level of tax, post indexation, both for coupon and capital gains. 

I am not holding my breath on any of this happening – this might be consigned to the Dilbert folder for a while. But if you do see reasons why current status quo actually makes sense, please do chip in – happy to be proven wrong, and remove this item from the folder!