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How tax saving bonds can help you

December 27, 2010 15:35 IST

When Ravi Sharma sold property that he had purchased a decade ago, he made a handsome profit on it. But along with this, came the capital gains tax liability. He now had two options.

He could invest the capital gains in Section 54EC bonds that are currently being issued by Rural Electrification Corporation and National Highways Authority of India and thereby save the entire amount. Or he could actually pay the tax and invest the balance in quality equity funds.

Sharma was inclined towards the second option. The bonds offer a low annual interest rate, currently six per cent and are taxable. Plus, the money remains locked for three years. We decided to run some numbers.

The analysis saw Sharma clutching the application form for the bonds. Section 54EC bonds may also be used to save tax on long-term capital gains from sale of non-equity mutual funds, bonds, debentures, gold, jewellery or even gold exchange traded funds.

GAME PLAN
In spite of the fact that the returns are low, the interest taxable and a three-year lock-in. To know why, examine the table.

The key thing is that on account of being a tax saving bond, they  effectively offer investors an up-front 20 per cent discount. It is like investing Rs 80 but earning a return on Rs 100. Also, the 20 per cent gets spread over just the three-year lock-in period of the bonds.

So, say the investor earned a capital gain of Rs 100. Effectively, he will end up investing Rs 80 in the bonds, as he saves a tax of Rs 20.

At six per cent, he earns Rs 6 every year and at the end of three years, he gets his original investment back. The net equivalent return works out to an eye popping 12.6 per cent yearly, after tax. And if the investor does not have other taxable income, the return climbs to 14.7 per cent per annum.

Sharma's earlier idea was to pay tax and invest in equity funds. Let's say he were to invest Rs 1 lakh in the market. At 14.7 per cent per annum over three years, the money should grow to around Rs 1,51,000, that is almost 50 per cent more. And this is just to break even. After that, he will actually start making any money.

CAP AT Rs 50 LAKH
There is only one drawback to these bonds - the maximum investment in any one financial year is capped at Rs 50 lakh. Considering the way property prices have spiralled, some investors may find this amount enough to cover the entire amount of capital gains.

However, some planning may help. Remember, you have six months to invest in the bonds from the time of earning the capital gain.

If you find you would need a tax cover of more than Rs 50 lakh, time the sale transaction between December and March of any year. This way, the six-month period would overlap two financial years and enable you to double the investible amount to Rs 1 crore.

The writer is Director, Wonderland Consultants.

Sandeep Shanbhag in Mumbai
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