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Use Interest Stripping to reduce Tax
Investors in the high tax bracket can use tax-free bonds to reduce their capital gains tax.
Tax planning is not just about investing in certain schemes to claim tax deduction under Section 80C at the end of the financial year. You also need to make sure that the tax on returns from your investments is reduced. There's no need to worry about the tax on long-term equity investments because the dividends and long-term capital gains are exempt from tax. However, tax planning becomes critical when it comes to your investments in debt instruments.
Interest stripping is a tax planning strategy that can help high net worth individuals (HNIs) and investors in the high tax bracket to reduce their tax burden.
This strategy involves buying a bond just before the `record date' for interest payment (or income interest) and selling it after pocketing the interest. However, there will be some gap between ex-interest date and the actual interest payment date. The market prices of all bonds include the accumulated interest till that date. In other words, the market price of bonds will fall after the record date and the quantum of fall will be equal to the interest received by you. This strategy, however, will not work with normal bonds because the interest is taxable and, therefore, it would negate the benefit of short-term capital losses you make using this strategy.
Interest stripping works well with tax free bonds because the interest is tax free and short-term capital losses booked can be set off against other short-term capital gains. The time is ripe to use this strategy because the interest is due on several tax free bonds
However, you need to be careful while executing this strategy, Section 94 (7) of the Income Tax Act puts restrictions on such strategies. According to the section, the tax-free interest earned in the middle will be added back to the sales price before arriving at the capital gains in certain conditions. To avoid this, you have to buy the security three months before the record date. This is not difficult because the interest payment date every year is known well in advance. So, you will have to purchase the bond and hold it for at least 3 months. If you sell the bond after three months, the price would have fallen and the notional loss made by you can be adjusted against certain other taxable capital gains. The risks involved Buying a bond for three months would mean you are taking a short-term gamble in the debt market. If the interest rates rise in the meantime, the price of the bond could come down, negating any gains from the tax arbitrage. You could, however reduce the risk by holding the bond for a longer period. This is because the probability of rates coming down is much higher compared to the rates going up in the next 12 months or so. The 10-year yield is expected to come down by at least 50 basis points from current levels in the next one year. The decline in inflation due to the fall in international crude prices is the main reason behind this. The recent government initiatives, such as decontrol of diesel and the fall in India's fiscal deficit, is another factor that has brought inflation down. If you extend the holding period by a little more than one year, you can get two tax free interest payments
Though it is an effective strategy, you need to take some precautions while implementing it. "Restrict yourself to bonds with enough liquidity. Buy bonds where the issue size is at least `500 crore to ensure higher liquidity. How does the strategy work To understand how the strategy works, let us consider the 8.3% tax-free bonds issued by Power Finance Corporation (PFC) during the financial year 2011-12. The PFC bond was quoting at `1,085 on 20 September 2013, five days before its record date. Five days after the second interest payment in 2014 it was at `1,079. The interest payment date comes sometime after the record date. Since the buying price and selling price are almost equal, there are capital gains made here. However, the investor receives two tax-free interests of 8.3% each (`83 each because interest is calculated on the face value of `1,000) during the period. This works out to be an absolute tax-free return of 15.37% for a holding period of 13 months. If the interest rates continues to fall over the next one year, as expected, other tax-free bonds should also generate similar returns. Even if we assume an annual gain of, say, 12%, investors could still benefit by way of getting two tax free interest tranches and long-term capital losses that can be set off against other taxable capital gains.
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