Background
While debentures have been a common mode of raising debt for companies, there still remains ambiguity regarding the taxation of certain income earned from debentures. Taxation of premium received on redemption of debentures is one such issue.
The ambiguity in this regard can be attributed to the fact that a taxable transfer under the Income-tax Act, 1961 (“IT Act”), has been defined widely to, inter alia, include relinquishment of an asset or the extinguishment of any rights therein. Thus, taxpayers tend to argue that redemption premium should be taxed as capital gains, being payments received on extinguishment of a capital asset (i.e., debentures). However, the term ‘interest’ is also defined widely to mean any income earned in respect of any moneys borrowed or debt incurred. Consequently, it may be argued that since redemption premium is in the nature of income arising from a debt instrument, the same should be taxed as interest income.
Recently, the Mumbai Income Tax Appellate Tribunal (“ITAT”) in Khushaal C. Thackersey v. Assistant Commissioner of Income-tax,[1] had the opportunity to adjudicate on this issue. It was held that the premium received upon redemption of Non-Convertible Debentures (“NCDs”) is not capital gains, but interest which is taxable under the head “income from other sources”.
Brief Facts of the Case
In the said case, the taxpayer (an Indian tax resident) purchased NCD’s issued by an Indian company from certain nationalised banks. These NCDs offered 0% interest rate but were redeemable at a premium. When the NCDs matured, the taxpayer received the face value plus the premium back from the company. The taxpayer computed long-term capital gains by reducing its cost of acquisition from the maturity proceeds. It may be noted that while a beneficial rate of 20% (plus applicable surcharge and cess) is available in case of long-term capital gains, interest is taxed at rates ranging up to 30% (plus applicable surcharge and cess). Further, certain exemptions may be claimed in case of long-term capital gains. The taxpayer in the instant case, attempted to claim one such exemption on the capital gains earned by him.
On assessment, the tax officer held that the gain received on redemption of NCDs was in the nature of interest, assessable under the head ‘income from other sources’ and recomputed his tax liability. This was upheld by the first appellate authority under the IT Act. Aggrieved by the same, the taxpayer filed further appeal before the Mumbai ITAT.
The taxpayer argued that debenture is a ‘capital asset’ and its extinguishment would constitute a taxable transfer under the IT Act. For this, the taxpayer relied on the precedents where redemption of preference shares and capital investment bonds were considered “transfers” under the IT Act, thus, qualifying for capital gains treatment.[2] Furthermore, reliance was also placed on the recently introduced Section 50AA, which deems the gains arising from transfer, redemption, or maturity of “Market Linked Debentures” (“MLD”), to be taxable as capital gains. Thus, it was argued that this signifies that the IT Act recognises that redemption of debentures constitutes a taxable transfer, exigible to capital gains.
The tax authorities on the other hand contended that NCDs are simply debt instruments, and thus the premium received on redemption is nothing but interest income. They relied on Bennett Coleman & Co. Ltd, wherein it was held that premium received on redemption of debenture is taxable under the head of “income from other sources”.[3] The tax authorities further argued that the Central Board of Direct Taxes vide Circular 2/2005, dated February 15, 2002 (“Circular”), has clarified that the difference between redemption price and cost of purchase of deep discount bonds (“DDB”) by the intermediate purchaser is taxable as interest or business income.[4]
ITAT Ruling
The Mumbai ITAT ruled in favor of the tax authorities and held that premium on redemption of debentures is taxable as interest income. For this, the ITAT made the following observations:
- The discount on DDBs was the same as premium paid on redemption of NCDs since both were debt instruments, and the discount/ premium was determined by applying a particular interest rate.
- For MLDs, on the other hand, interest rate is not determined at the time of issuance, but return is dependent on the performance of an underlying market index or instrument. NCDs are materially different from MLDs, hence, no support can be drawn from Section 50AA.
- There is a difference between debentures and preference shares/ capital investment bonds as well as the rights and obligations emanating from them. Shares carry certain rights over and above their face value (such as right to receive surplus on liquidation), which are absent for debentures. Thus, the cases relied on by the taxpayer in support of there being a taxable transfer in the nature of an ‘extinguishment’ are distinguishable on facts.
- Redemption of an NCD happens at face value only vis-à-vis the issuer. Thus, such redemption will not give rise to any capital gains. It will merely constitute realisation of money advanced by a creditor. Any premium received will accordingly be in the nature of interest income.
The ITAT thus, treated the difference between the redemption value and the cost of acquisition of NCDs as interest income in the hands of the taxpayer. Further, the ITAT also opined that if NCDs are transferred to a third party in the open market for a price higher than their face value, then gains arising on such transfer will be subject to capital gains tax.
Significant Takeaways
This ITAT judgment upholds the principle that premium received on redemption of NCDs is generally taxable as interest under the head ‘income from other sources’. However, it is relevant to note that the judgment dealt with a specific situation (i.e., where NCDs were issued at 0% interest in lieu of an outstanding debt obligation), there could be other scenarios, like a buyback of interest-bearing NCDs before their maturity. In such cases, where the investor gives up the right to receive future interest for a one-time payment, the same could be considered an ‘extinguishment of rights’, potentially triggering capital gains tax implications in the hands of the NCD-holder. Thus, it will be important to analyse the impact of this ruling based on the specific facts and relevant tax principles.
Conclusion
This ITAT judgment provides valuable clarity on the tax treatment of premium received on NCDs. However, the strength of the principles highlighted herein will need to be tested as per the complexities of each case.
If you feel that this ruling may have an impact on you or you have any questions regarding the same, feel free to drop us a line on our contact details provided below.
For further information, please contact:
Kunal Savani, Partner, Cyril Amarchand Mangaldas
kunal.savani@cyrilshroff.com
[1] Khushaal Thackersey v. Assistant Commissioner of Income-tax, I.T.A. No. 367/Mum/201.
[2] Anarkali Sarabhai v. Commissioner of [1997] 90 Taxman 509 (SC); Mrs. Perviz Wang Chuk Basi v. JCIT, (2006)(102 ITD 123).
[3] Commissioner of Income Tax v. Bennett Coleman & Co. Ltd, 2013 SCC OnLine Bom 1961.
[4] Central Board of Direct Taxes (CBDT) Circular 2/2002 dated 15 February 2002.
