Capital gains tax exemption bond under section 54EC of the Income Tax Act, 1961 was introduced in the assessment year 2001-02 by sunsetting Sections 54EA and 54EB, which provided a basket of options to reinvest long term capital gains.
At that time, the justification given was that Section 54EC will help to channelise investments in a focused manner into agricultural finance and highway infrastructure.
Section 54EC explained
As it stands at this moment, Section 54EC exempts capital gains of up to Rs 50 lakhs arising from the transfer of long term capital assets. This exemption is presently available for long term capital gains arising only from the transfer of land or building or both.
The condition is that such gains are invested in notified bonds within six months from the date of transfer the long term capital assets. Capital gains tax exemption bonds issued by the National Highways Authority of India (NHAI), the Rural Electrification Corporation Limited (REC), the Power Finance Corporation Limited (PFC), and the Indian Railway Finance Corporation Limited (IRFC) are presently notified under section 54EC. The bonds have to be held for a minimum of 5 years.
The Finance Act 2018 made two significant changes to the benefits offered by Section 54EC--it limited the scope of exemption to capital gains arising only from land or building or both and increased the holding period of the notified bonds to 5 years.
Prior to the Finance Act 2018 amendment, Section 54EC exempted capital gains arising from the transfer of any long term capital asset, and the holding period of the notified bonds was a minimum of 3 years to qualify for exemption.
Do Section 54EC bonds make a compelling case for investing capital gains?
Although the Section 54EC bonds are perceived as offering a low interest rate, this is not the true case. An illustration will throw more light on this.
Suppose, a person sold land or building or both and earned long term capital gains of Rs 1 lakh from such sale. If this capital gain was invested in NHAI bonds, the bonds would entitle the person to interest payment (coupon) of 5.75 per cent/annum every year for 5 years.
The bonds would mature and the person would get his principal of Rs 1 lakh back at the end of 5 years. The effective investment for such a person would be Rs 70,000 assuming the person is in the 30 per cent tax slab. The interest income from these bonds is subject to tax at the slab rate at which the person is taxed. The post-tax internal rate of return (IRR) for such a person works out to almost 12.5 per cent.
Therefore, unless such a person can find alternative avenues for generating post-tax returns in excess of 12.5 per cent, these bonds make compelling case. Also, not only the returns, the AAA credit making also makes the bonds attractive.
Bonds issued under Section 54EC by NHAI, REC, PFC and IRFC are exempt from tax deduction at source (TDS) under clause (iib) of section 193. However, the interest continues to be subject to tax in the hands of the assessee.
Sunset in the offing
Over time, the scope of Section 54EC bonds have been narrowed down with the most recent one being the limitation introduced by the Finance Act 2018.
The biggest narrowing of scope was done by the Finance Act 2007. Finance Act 2007 limited the maximum investment that an assessee could make in such bonds to Rs 50 lakh and restricted the exemption to only bonds issued by NHAI and REC.
When the section was introduced by the Finance Act 2000, it envisaged exemption for bonds issued by the National Bank for Agriculture and Rural Development (NABARD), and the NHAI. Finance Act 2001 and 2002 expanded this exemption to bonds issued by REC, National Housing Bank (NHB), and the Small Industries Development Bank of India (SIDBI).
In recent times, PFC and IRFC were notified as borrowers whose bonds will qualify for exemption, if the terms of the bonds meet the criteria under section 54EC. However, the size of issuance of such bonds is miniscule compared to PFC and REC's overall borrowing programme.
Time and again the government has indicated its intent to phase out deductions and rationalise tax rates. Whether or not the proposed new Direct Tax Code materialises and whether or not tax rates are rationalised, signals from the government clearly indicate that phasing out exemptions is one of their priority areas.
Could Section 54EC then become next fall guy? While it is difficult to answer this question, it definitely makes sense to take advantage of the benefits offered by this section, as long as it lasts.
Vasudevan is Partner and Sriram is Principal Associate, Lakshmikumaran & Sridharan