A recent circular of the Central Board of Direct Taxes (CBDT) has turned the understanding of income-tax law on its head.
The circular in question is circular no 2 of 2002 dated February 15, 2002, reported in 254 ITR (St) 241. This circular deals with the tax treatment of deep discount bonds and strips.
Deep discount bonds (DDBs) basically represent money given to an institution for an extended period of time. The issue price may be "X" but the redemption price at the end of the extended period is say "3X". In the intermediate period between the issue date and the redemption date, the said bonds may be transferable either in its entirety or in portions of it, if such a provision exists in the terms of the issue. When only a part of the bond, may be the interest coupons, are sold in the market, the strip portion of the bonds is capable of being traded independently.
So far, by virtue of clarification letters issued to the Reserve Bank of India which has issued DDBs, if a bond is transferred before redemption, the consideration received is treated as a capital gain. However, in the hands of the person who is encashing the DDB at the time of redemption, the amount received is treated as interest in his hands.
The circular states four reasons why the system currently being followed should be substituted by a new system. These are :
(i) Taxing the entire income received from such a bond in the year of redemption as interest income gives rise to a sudden and huge tax liability in one year whereas the value of the bond has been progressively increasing.
(iii) A company issuing such bonds and following the mercantile system of accounting may evolve a system for accounting of annual accrual of the liability in respect of such a bond and claim a deduction in its assessment for each year even though the corresponding income in the hands of the investor would be taxed only at the time of maturity.
For this reason, the new treatment proposed by the circular is as under:
(i) Market valuation of the bond is to be made on 31st March of each financial year.
(ii) The difference between the market values on two successive valuation dates will be treated as interest.
(iii) If the bond is acquired during the year