Interest on Securities

In income-tax parlance, security is a document possessed by the creditor as a guarantee for the payment indebted to him. Interest on securities refers to any of the following types of income:

Interest on any security which has been issued by the Central Government or State Government.
Interest on debentures or other securities for money issued by on or behalf of a local authority or a company/co-operation established by a Central, State or Provincial Act.

Basis of Charge

If the assessee maintains books of account on a cash basis, interest by way of interest on securities is taxable on receipt basis. If the books are being maintained on the mercantile system, it is taxable on due basis. It is again taxable on receipt basis if such interest had not been charged to tax on the due basis for any earlier previous year.

Due Date of Interest

Interest on securities does not accrue on a daily basis or according to the period on which investment is held. It becomes due on the due dates specified on securities.

Interest Exempt from Tax

Interest on notified securities, as well as notified bonds and certificates, are fully exempt from tax. Also, interest on Post Office savings bank account is exempt up to an amount of Rs 3,500 with respect to an individual, and Rs 7,000 in the case of a joint account.

Grossing up of Interest

Grossing up mechanism specifies that the payer must ensure complete payment of the amount due to the recipient, which precisely means that the payer must cover the tax deduction costs of the payee. Gross interest, which is derived after adding net interest with tax deducted at source, is taxable. Net interest is grossed up in the hands of the recipient if the payer deducts tax at source. Net interest is grossed up by using the following formula:

100/ (100 – Rate of tax deduction at source)

Avoidance of Tax

As already discussed, interest on securities does not accrue on a daily basis, but on certain stipulated dates. Given this scenario, there might be instances where a person transfers securities to another person on a few days or even the evening prior to the due date and reacquires the same or similar securities after the receipt of interest by the transferee. This would enable the transferor to evade tax in respect of such interest. Such a transaction is popularly known as a bond washing transaction. The following measures have been suggested to prevent tax avoidance:

When Income Belongs to the Transferor

Section 94(1) of the Income-tax Act provides that, if a security owner transfers the securities on the eve of the due date of interest and acquires them back at a later point of time, the interest received by the assessee will not be a part of the assessee’s income, but the transferor’s, thereby forcing the transferor to remit his/her tax dues.

When Tax is Avoided through Sale of Interest-bearing Securities

Other than what is known as a bond washing transaction, sale of securities cum-interest is another method of avoiding tax. Selling of sales cum- interest refers to a situation where an assessee, who holds a beneficial interest in securities during the previous year, sells them in a manner that either no income is received or income received is lesser than the sum he would have received if interest had accrued on a daily basis. In this case, income from securities for the particular year would be deemed as income of such person. The aforementioned anti-avoidance measures are not applicable if the owner of securities proves to the satisfaction of the Assessing Officer that there has been no avoidance of income tax or the avoidance of income-tax was exceptional and not systematic, and hence there was not any avoidance of income-tax.