Gains on Transfer of Deep Discount Bonds Are Long-Term Capital

Gains on Transfer of Deep Discount Bonds Are Long-Term Capital Gains Eligible for Section 54EC Benefit Without Annual Interest Accrual Addition

Issue

Whether gains arising from the transfer of interest coupon strips/Deep Discount Bonds (DDBs) are assessable as long-term capital gains based on the period of holding, making the assessee eligible for deduction under Section 54EC.
Whether Circular No. 2/2002 dated 15.02.2002 applies retrospectively to tax annual accrued interest on DDBs issued prior to its issuance.
Whether the addition made by the Assessing Officer on account of accrued interest on DDB investments is legally sustainable.

Facts

The assessee held investments in Deep Discount Bonds (DDBs) issued by ICICI Ltd. and Infrastructure Leasing and Financial Services Ltd. (IL&FS) during the Assessment Year 2002-03.
The Assessing Officer made an addition to the assessee’s taxable income on account of annual accrued interest on these DDB investments.
The assessee claimed that the gains realized on the transfer of the interest coupon strips/DDBs were long-term capital gains based on the holding period and claimed exemption/deduction under Section 54EC of the Income-tax Act, 1961.
The Revenue relied on CBDT Circular No. 2/2002 dated 15.02.2002 to justify taxing the accrued interest income on DDBs annually.

Decision

Long-Term Capital Gains & Section 54EC Eligibility: Decided in favour of the assessee. The gains arising from the transfer of interest coupon strips/DDBs are to be assessed as long-term capital gains based on their period of holding, and the assessee is entitled to claim deduction under Section 54EC.
Prospective Application of CBDT Circular: Decided in favour of the assessee. Circular No. 2/2002 dated 15.02.2002 specifies the tax treatment for bonds issued after its date of issuance and does not retrospectively alter the tax treatment for existing bondholders.
Deletion of Accrued Interest Addition: Decided in favour of the assessee. The addition made on account of annual accrued interest on DDB investments was held to be unsustainable and accordingly deleted.

Key Takeaways

Capital Gains Treatment for DDB Transfers: Income generated from the transfer of Deep Discount Bonds and interest coupon strips is categorized as capital gains based on the holding period, enabling assessee eligibility for capital gains exemptions like Section 54EC.
Non-Retrospectivity of Tax Circulars: CBDT Circulars introducing new tax mechanisms (such as annual accrual taxing on DDBs) apply only prospectively to instruments issued after the circular’s release date and cannot retroactively impact rights and expectations of existing bondholders.
No Deemed Accrual for Pre-Circular Bonds: Taxpayers holding DDBs issued prior to Circular No. 2/2002 are not required to pay tax on hypothetical annual accrued interest prior to maturity or transfer.

HIGH COURT OF GUJARAT

Commissioner of Income-tax

Kisan Discretionary Family Trust

Bhargav D. Karia and Nirzar S. Desai, JJ.

R/TAX APPEAL NO. 540 of 2012^†

OCTOBER 15, 2026

Utkarsh R. Sharma, Adv. for the Appellant. S.N. Soparkar, Sr. Adv. and B.S. Soparkar for the Respondent.

JUDGMENT

Bhargav D. Karia, J. – Heard learned Senior Standing Counsel Mr. Utkarsh R. Sharma for the appellant and learned Senior Advocate Mr. S.N. Soparkar with learned advocate Mr. B.S. Soparkar for the respondent.

2. This Tax Appeal is filed by the Revenue under section 260A of the Income Tax Act, 1961 (For short “the Act”) against the judgment and order dated 31.01.2012 passed by the Income Tax Appellate Tribunal, “A” Bench, Ahmedabad (For short “the Tribunal”) in ITA No. 1261/Ahd/2006 for Assessment Year 2002-2003. Tax Appeal was admitted by this Court vide order dated 05.09.2012 raising the following substantial questions of law:

“1. Whether the Appellate Tribunal has substantially erred in deleting the addition of Rs. 45,15,49,625/- in respect of accrued interest on investment in DDBs of ICICI Ltd. and Infrastructure Leasing and Financial Services Ltd. ?

2. Whether the Appellate Tribunal has substantially erred in deleting capital gain of Rs. 4,51,34,165/- whether short term or long term capital gain and eligibility of deduction under section 54EC of the Act ?”

3. So far as question no. (1) is concerned, same is answered in favour of the assessee and against the Revenue in view of order of even date passed in Tax Appeal No.209/2010 by this Court.

4. Insofar as Question no. (2) is concerned, brief facts of the case are that during the year under consideration, the assessee was allotted 47 Tata Finance Ltd. Non-convertible debentures, Series I as on 23.03.2000 each of Rs.1,00,00,000/-. Each debenture comprised Principal strips Part-A, and five detachable interest coupon strip namely, Part-B, Part-C, Part-D, Part-E and Part-F being interest coupon payable at a periodic intervals of 15, 27, 39, 51 and 63 months from the deemed date of allotment. Similarly, the assessee was allotted 2 Tata Finance Ltd. Non-Convertible debentures, Series II as on 23.03.2000 each of Rs.25,00,000/-. Each debenture comprised Principal strips Part-A, and five detachable interest coupon strip namely, Part- B, Part-C, Part-D, Part-E and Part-F being interest coupon payable at a periodic intervals of 15, 27, 39, 51 and 63 months from the deemed date of allotment. The assessee sold the interest coupon strips, Series-I Part-B as on 18.05.2001 to Birla Sun Life Mutual Fund and rest of the interest coupon strips, Series-I i.e. Part-C, D, E, and F as on 22.03.2002 to Nirma Ind. Ltd. and reflected Long Term Capital Gain on these transactions. Similarly, the assessee sold the interest coupon strips, Series-II Part-B as on 19.05.2001 to Ishan Consultancy Services and rest of the interest coupon strips, Series-II i.e. Part-C, D, E and F as on 20.03.2002 to Nirma Ind. Ltd. and reflected Long Term Capital Gain on these transactions.

5. A show cause notice was issued as to why the accrued interest should not be considered as on 31.03.2001 on the discounted value of the strips and then from this date why short term capital gain should not be considered on the interest coupon strips in light of the Board’s Circular No.2 of 2002 dated 15.02.2002. The assessee submitted his reply that the said Circular is not applicable and relied on CBDT’s letter dated 12.03.1996 and Press Release dated 20.03.2002 issued by the CBDT.

6. The Assessing Officer did not accept the claim of the assessee and treated the capital gains as Short Term Capital Gain.

7. The CIT(Appeals) confirmed the order of the Assessing Officer.

8. Being aggrieved by the order passed by CIT(Appeals), the assessee preferred appeal before the Tribunal. The Tribunal followed the decision in case of Karsanbhai Khodidas Patel HUF v. ACIT [IT Appeal No. 1042 (Ahd.) of 2006, dated 9.10.2009] and held as under:

“9. The Respected Co-ordinate Bench has held that the capital gain arising on sale of Deep Discount Bond should be assessed as Long Term Capital Gain on the footing that the period of holding of Deep Discount Bond is more than the period prescribed. The Respected Bench has also opined that the Circular No.2 of 2002 issued by CBDT on 15/02/2002 was not relevant for deciding the issue whether the gain is long term or not. The Respected Bench has considered the provisions of section 2 (42A) also. Thus, the totality of the circumstances warrants to follow the aforesaid decision of the Tribunal. In the result, this ground of the assessee is hereby allowed. “

9. In view of above findings of the Tribunal, the Tribunal held that the assessee is entitled to exemption under section 54EC of the Act in view of its finding that gain in question was to be taxed as long term capital gain.

10. We are in complete agreement with the findings recorded by the Tribunal by relying upon the decision in case of Karsanbhai Khodidas Patel HUF (supra) wherein in similar facts, it was held that the capital gain arising on sale of Deep Discount Bond should be assessed as long term capital gain on the footing that same was held for a period of more than 12 months and as a consequence, the assessee is also entitled to exemption under section 54EC of the Act as claimed.

11. Reliance is also placed on behalf of the assessee on the Letter F.No.225/45/96 IT (A- II) dated 12.03.1996 issued by the Central Board of Direct Taxes for clarification of capital gain chargeable as regarding the taxability of the income relating to Deep Discount Bonds which reads as under:

“It is clarified that the difference between the issue price and the redemption price of Deep Discount Bonds will be treated as interest income assessable under the Income- tax Act. On transfer of Bonds before maturity, the difference between the sale consideration and issue price will be treated as Capital Gains/Loss if the assessee purchased them by way of investment. However, in the case of an assessee who deals in purchase and sale of Bonds, Securities, etc., the profit or loss shall be treated as trading profit or loss.

The decision on other issues, referred to in your letter shall be communicated in due course.”

12. Circular No.2/2002 dated 15.02.2002 has also clarified as under:

“There have been certain reports in the press recently, suggesting that the tax treatment of Deep Discount Bonds as specified in Circular No.2/2002, dated February 15, 2002 [See (St.) issued by the Central Board of Direct Taxes is anomalous, as it provides for taxation of income from such bonds on an annual basis, even though no income is received by the bond-holder before maturity. It has been opined that a heavy tax burden is being placed on persons who have been holding such bonds for a while, and a cumbersome obligation of valuing the bonds every year on the basis of RBI Guidelines is being cast on small Investors. The reports are mis-conceived and based on an incorrect understanding and inadequate knowledge of facts and law. The modified tax treatment now specified in fact corrects the anomalies in the existing system by providing a mechanism for taxing income accruing from year to year on deep discount bonds, on the same lines as income from normal coupon bearing bonds is taxed. Transfer of the bonds before maturity will attract capital gains tax, as in the existing system.

The earlier system of taxing the entire income received from such bonds in the year of redemption as interest income was anomalous in that it gave rise to a sudden and huge tax liability in one year whereas the value of the bond had been progressively increasing over the period of holding. Further, where the bond was redeemed by a person other than the original subscriber, such person was taxed on the entire difference between the bid price and the redemption price as interest income. Such a system also created tax-induced distortions in the debt market, and was an impediment to the development of a market in STRIPS, which are essentially zero coupon instruments derived from normal coupon bearing bonds.

Taxation of income on accrual basis is an established principle of law, and always results in taxing income that has not yet been received. Income from deep discount bonds accrues continuously over the period of holding and can be realized at any time by selling the bond. Taxing income from such bonds on accrual basis annually is, in fact, a practice followed world-wide.

It is also an established principle that a circular issued by CBDT cannot have a retrospective tax effect. The present circular on deep discount bonds, therefore, specifies the tax treatment in respect of bonds which are issued after the issue of the circular, and does not seek to impose the modified treatment on existing bond- holders. Further, non-corporate persons who invest small amounts in new issues (face value upto Rs.1 lakh) can still opt for the old system.

Valuing the bonds every year on the basis of RBI Guidelines will not pose any problem as such values can be obtained from the issuers themselves, who will invariably be the RBI or a public financial institution.

The amount received on redemption would always be liable to tax deduction at source as per normal provisions of the Income-tax Act. However, no TDS is required on interest payable on Government securities, and bonds issued by an institution, authority, public sector company or co-operative society can also be exempted from the requirement by notification.”

13. By Press Note dated 20.03.2002, the aforesaid clarification has been published.

14. In view of above clarification issued by CBDT also, once the capital gain earned by the assessee of Rs.4,51,34,165/- is to be treated as a long term capital gain being eligible for deduction under section 54EC of the Act, question no. (2) is therefore, answered in favour of the assessee and against the Revenue.