Circular On Deep Discount Bonds Violates Tax Principles

Updated: Apr 1 2002, 05:30am hrs
A recent circular of the Central Board of Direct Taxes (CBDT) has turned the understanding of income-tax law on its head.

The circular in question is circular no 2 of 2002 dated February 15, 2002, reported in 254 ITR (St) 241. This circular deals with the tax treatment of deep discount bonds and strips.

Deep discount bonds (DDBs) basically represent money given to an institution for an extended period of time. The issue price may be "X" but the redemption price at the end of the extended period is say "3X". In the intermediate period between the issue date and the redemption date, the said bonds may be transferable either in its entirety or in portions of it, if such a provision exists in the terms of the issue. When only a part of the bond, may be the interest coupons, are sold in the market, the strip portion of the bonds is capable of being traded independently.

So far, by virtue of clarification letters issued to the Reserve Bank of India which has issued DDBs, if a bond is transferred before redemption, the consideration received is treated as a capital gain. However, in the hands of the person who is encashing the DDB at the time of redemption, the amount received is treated as interest in his hands.

The circular states four reasons why the system currently being followed should be substituted by a new system. These are :
(i) Taxing the entire income received from such a bond in the year of redemption as interest income gives rise to a sudden and huge tax liability in one year whereas the value of the bond has been progressively increasing.
(iii) A company issuing such bonds and following the mercantile system of accounting may evolve a system for accounting of annual accrual of the liability in respect of such a bond and claim a deduction in its assessment for each year even though the corresponding income in the hands of the investor would be taxed only at the time of maturity.

For this reason, the new treatment proposed by the circular is as under:

(i) Market valuation of the bond is to be made on 31st March of each financial year.
(ii) The difference between the market values on two successive valuation dates will be treated as interest.
(iii) If the bond is acquired during the year by an intermediate purchaser, the difference between the market value on the valuation date and the cost for which he acquired the bond will be treated as interest.

Transfers before maturity :
(iv) Transfers before maturity date will entail a capital gain representing the difference between the sale price and the cost of the bond. If in the intervening period some income has been offered as per (iii) above, this income too will be added in arriving at the cost.
(v) The period of holding would be the date of the purchase or the last valuation date in respect of which income is offered, whichever is later. The circular goes on to state that since such period would always be less than one year the capital gains would be considered as short-term.

(vi) The difference between the redemption price and the value on the last valuation date will be taxed as interest income in the hands of the original subscriber.
(vii) In the hands of the intermediate purchaser the difference between the redemption price and the cost of the bond to the purchaser will be taxable as interest income. Cost of the bond would include all amounts charged as interest in the intervening period.

No date has been given from which the circular is effective and hence the circular will be effective from and including assessment year 2002-2003.

This circular violates all principles of established tax law. That the DDB is a capital asset is undisputed. The circular itself treats intermediate sales as short-term capital gains. In this regard attention is also invited to the third proviso to section 48 of the Act whereby the provisions of indexation are made inapplicable to bonds other than capital indexed bonds, thus implying that bonds are capital assets.

In fact the statement treating all gains as short-term misses out on the fact that, in the first year of the circular, there may be original purchasers or intermediate purchasers who may have not offered income to tax in their hands, thus making the profit on sale a long-term capital gain, if it is held for more than three years.

Once it is established that the DDB is a capital asset, the CBDT has no power to treat notional amounts as interest income. The heads of income are defined. If an income falls under a particular head, unless the Act is amended, there is no way in which a capital gain resulting from transfer of a capital asset can be treated as interest by the CBDT. A beneficent circular may be binding on the department, but certainly a circular which goes against the basic tenets of law would not be binding on the assessee if he chooses to ignore the same.

There is yet another reason why the circular is bad in law, even assuming that the intervening notional income can be taxed as interest income. An investor normally does not maintain books of account. If such is the case, the income can only be taxed on a receipt basis and not on an accrual basis. In respect of income from other sources, if he does maintain books, the treatment of the interest income should be as per the method of accounting followed by him.

One will recall that there is a circular which allows an assessee to treat the interest income on cumulative time deposits as income of each year to the extent accrued each year. Even here, it is only if the assessee opts for this treatment that the AO could tax it as such. If he does not opt for this treatment, the entire interest necessarily has to be assessed in the year of receipt of the cumulated interest.

I have always maintained that even the earlier clarification was not correct because income from transfer of a capital asset can never be considered as interest income. The earlier position, however, was not set out in any circular and was only being followed as a method on the basis of the clarifications given to the RBI. Now, however, the circular goes well beyond the law and could easily be struck down.

Lastly, the whole purpose of the circular was to overcome the anomaly of the entire tax being deducted in one year, namely, the year of redemption. Unfortunately, this problem has not disappeared by virtue of the circular, since the circular itself says that the difference between the bid price of a DDB and its redemption price at maturity will continue to be subject to tax deduction at source.

The CBDT should immediately seize itself of the anomalies in the circular and the fact that it violates all tax norms and clarify once and for all that the DDBs are capital assets and at the time of their sale or even at the time of their redemption what would result would be a capital gain. Or, the law should be amended.