Taxation of Bonds & Debentures in India

A practical guide to interest income, capital gains, TDS and special categories — updated for FY 2025-26 and the Income-tax Act, 2025

Bonds and debentures have quietly become one of the most popular ways for Indian investors to earn steady, predictable income — and for good reason. They’re less volatile than equity, often more rewarding than a fixed deposit, and today’s market gives you everything from government securities to corporate NCDs to sovereign gold bonds. But the return you actually keep depends on how well you understand the tax rules that sit underneath these instruments. This guide walks through exactly that — in plain language, with the current rates and thresholds you need for FY 2025-26 (AY 2026-27), and a look ahead at how things read under the new Income-tax Act, 2025.

1. First, the Building Blocks: Types of Bonds and Debentures

Before getting into tax treatment, it helps to know what you’re holding. Indian debt instruments fall into a few overlapping categories, and the classification you fall into often decides which tax rule applies.

By security

• Secured debentures: Backed by a charge on the issuer’s assets, so investors have a claim to recover money if the issuer defaults.
• Unsecured debentures: Backed only by the issuer’s creditworthiness, with no specific asset as collateral — typically offering a slightly higher coupon to compensate for the added risk.

By convertibility

• Convertible debentures: Can be converted into equity shares of the issuing company after a specified period.
• Non-convertible debentures (NCDs): Popularly called NCDs, these repay only in cash and never convert into shares — the most common structure for corporate bond issuances.

By listing status — the most tax-relevant distinction

• Listed bonds: Traded on a recognised stock exchange (BSE/NSE). This status matters enormously for tax purposes, as you’ll see shortly.
• Unlisted bonds: Privately placed or otherwise not traded on an exchange. Tax treatment here has become notably less friendly in recent years.

Common instruments you’ll come across

• Corporate bonds / NCDs – issued by companies and financial institutions, may be listed or unlisted.
• Government securities (G-Secs) – issued by the Government of India and state governments, considered near risk-free.
• Tax-free bonds – issued historically by entities like NHAI, REC, PFC and IRFC, offering tax-exempt interest.
• Capital gain bonds – (rebranded as Section 85 bonds under the Income-tax Act, 2025) issued by REC, PFC, IRFC and NHAI specifically to help investors save capital gains tax.
• Sovereign Gold Bonds – (SGBs) issued by the RBI on behalf of the Government, denominated in grams of gold.
• RBI Floating Rate Savings Bonds, 2020 – a popular small-savings option carrying a floating coupon reset every six months.
• Perpetual bonds / AT1 bonds – issued mainly by banks and NBFCs to shore up capital; these carry no fixed maturity and higher risk.
• Zero-coupon bonds – issue at a discount and redeem at face value with no periodic coupon; the entire return is booked at maturity (or sale).
• Market-linked debentures (MLDs) – a category that has seen its tax treatment tightened considerably — more on this below.

2. Taxation of Interest Income

This part is refreshingly simple: coupon or interest income from a bond or debenture is taxed as “Income from Other Sources” and added to your total income, taxed at your applicable slab rate. There’s no special concessional rate for interest, regardless of whether the bond is listed, unlisted, government-issued or corporate — with one notable exception discussed below.

TDS on interest — Section 193

Under Section 193, tax is generally deductible at 10% on interest on securities, subject to specified thresholds and exemptions:

• Small-investor exemption: interest on debentures issued by companies and credited/paid through account payee cheque, where the aggregate does not exceed the prescribed threshold in a financial year, is exempt from TDS — though it remains fully taxable in your hands.
• Government securities: TDS is generally not deducted on interest from Central or State Government securities paid to resident holders, though the income is still taxable at slab rate.
• No-PAN penalty: if a valid PAN is not furnished, the deduction rate can rise to 20%.
• New declaration mechanism: from April 2026, a unified self-declaration form (Form 121) replaces the erstwhile Form 15G/15H, allowing eligible resident taxpayers whose total income is below the taxable threshold to avoid TDS at source.

Tax-free bonds — the interest exemption

Interest on notified tax-free bonds (issued historically by NHAI, REC, PFC, IRFC and similar entities) is fully exempt under Section 10(15). This is a genuine exemption — not merely a deferral — and no TDS is deducted, so you receive the full coupon. That said, this exemption applies only to interest. If you sell a tax-free bond in the secondary market before maturity and book a profit, that profit is a capital gain and is very much taxable under the rules discussed in the next section.

Sovereign Gold Bonds

Interest on SGBs (currently 2.5% per annum, paid semi-annually) is taxable at your slab rate, with no TDS deducted by the issuer. Capital gains, however, get special treatment — covered separately below.

3. Taxation of Capital Gains — Where Listing Status Really Matters

If you sell a bond in the secondary market, or it matures at a value higher than your cost (as with a zero-coupon bond bought at a discount), the profit is a capital gain. This is where the listed-versus-unlisted distinction becomes the single most important factor in your tax outcome, especially after the changes introduced by the Finance (No. 2) Act, 2024.

Listed bonds and debentures

• Held for 12 months or less (short-term): gain is added to your total income and taxed at slab rate.
• Held for more than 12 months (long-term): taxed at a flat 12.5%, with no indexation benefit available.

Unlisted bonds and debentures — always short-term now

This is the change that catches many investors off guard. Under Section 50AA, capital gains from unlisted bonds, unlisted debentures, and market-linked debentures (MLDs) transferred, redeemed or maturing on or after 23 July 2024 are deemed to be short-term capital gains, irrespective of how long you actually held the instrument — and taxed at your slab rate. The earlier route of paying a flat 20% (unlisted, held beyond 36 months) with indexation no longer applies to instruments covered by this provision.

Practical takeaway: the tax gap between listed and unlisted debt has widened considerably. If you’re evaluating a corporate NCD, always check its listing status before assuming a long-term, lower-rate outcome is available.

Zero-coupon bonds

A notified zero-coupon bond is specifically defined under Section 2(48), and the discount earned (maturity value minus issue price) is treated as a capital gain rather than interest. The listed/unlisted classification and the corresponding holding-period rules above apply in the usual way.

Sovereign Gold Bonds — the maturity exemption

SGBs carry a genuinely favourable rule: capital gains arising to an individual on redemption of an SGB at maturity (i.e., on RBI’s redemption at the end of the 8-year tenure) are exempt from capital gains tax. This exemption applies only to redemption on maturity by an individual — if you sell an SGB earlier in the secondary market, normal capital gains rules (listed-security treatment, since SGBs are exchange-tradable) apply instead.

Conversion of debentures into shares

Converting a debenture into equity shares of the same company is not treated as a ‘transfer’ for capital gains purposes — so no tax arises at the point of conversion. The holding period and cost of the original debenture simply carry forward to the converted shares, and tax is triggered only when those shares are eventually sold.

4. Capital Gain Bonds: Saving Tax under Section 54EC (now Section 85)

Separate from tax-free bonds, capital gain bonds — issued by REC, PFC, IRFC and NHAI — let you save long-term capital gains tax arising from the sale of land or a building. Key conditions to keep in mind:

• Investment cap: up to ₹50 lakh of LTCG can be invested per financial year.
• Time window: investment must be made within 6 months of the date of transfer.
• Lock-in: funds are locked in for 5 years; premature encashment or a loan against these bonds triggers withdrawal of the exemption.
• Interest is not tax-free: interest on these bonds is taxable at slab rate — only the capital gains exemption is the benefit, not the coupon.

Under the Income-tax Act, 2025, this exemption is renumbered as Section 85, but the substantive conditions carry forward largely unchanged.

5. Quick Reference: Tax Treatment at a Glance

Instrument / Situation	Interest / Coupon	Short-Term Capital Gains	Long-Term Capital Gains
Listed bonds/NCDs (held ≤ 12 months)	Slab rate	Slab rate	—
Listed bonds/NCDs (held > 12 months)	Slab rate	—	12.5%, no indexation
Unlisted bonds/debentures/MLDs	Slab rate	Always STCG at slab rate (Sec. 50AA)	Not applicable
Tax-free bonds (NHAI/REC/PFC/IRFC)	Exempt u/s 10(15)	Slab rate (if sold early)	12.5% if listed & > 12 months
Sovereign Gold Bonds – held to maturity	Slab rate	—	Exempt for individuals
Sovereign Gold Bonds – sold early (exchange)	Slab rate	Slab rate	12.5%, no indexation
Zero-coupon bonds	N/A (no coupon)	Slab rate, if unlisted/short holding	12.5% if listed & > 12 months
Section 54EC / Section 85 capital gain bonds	Slab rate	N/A – held for exemption purpose	N/A – held for exemption purpose

 

6. A Few Practical Pointers

• Listing status is worth checking before you buy, not after you sell: if a corporate NCD is listed, holding it past 12 months brings your gain down to a flat 12.5% instead of your slab rate — a meaningful saving for anyone in the 30% bracket.
• Tax-free doesn’t always mean best for everyone: tax-free bonds make sense mainly for those in higher tax brackets, since the exempt coupon needs to be compared against the after-tax yield of a taxable alternative.
• Plan Section 54EC/Section 85 investments early: if you’re planning to reinvest property sale proceeds, remember the 6-month window and the ₹50 lakh annual cap — plan the sale and reinvestment together rather than leaving it to the last month.
• Sovereign Gold Bonds reward patience: if you hold SGBs, simply riding them to the 8-year maturity converts your capital gains into a tax-free outcome — a rare and genuinely valuable planning tool.
• Track your holding period and listing status together: keep a simple log of purchase date, listing status and cost for every bond you hold — this alone resolves most of the classification questions above when it’s time to file your return.

Closing Thoughts

Bonds and debentures remain one of the more tax-efficient ways to diversify a portfolio — provided you know which rules apply to what you’re holding. The broad theme of recent reforms has been to reward listed, exchange-traded instruments with a longer holding period and a flat, moderate LTCG rate, while treating unlisted debt more strictly. None of this needs to be intimidating: with a little attention to listing status and holding period at the time of investment, most investors can plan their bond portfolios to keep taxes efficient and predictable.

This article is for general informational purposes and reflects the tax position as understood for FY 2025-26 / AY 2026-27, including transitional references to the Income-tax Act, 2025. Please consult your tax advisor for guidance specific to your situation.

 

Blog By : Mittal & Co.