Tax Implications of Investing in Government and Corporate Bonds

Taxes are a part of investments, which you cannot escape. As you gain returns on your investment, tax liability knocks on your door. For investments, it is typically capital gains on which you are required to pay taxes.

Capital gains are profits made by you when you sell your investments. It is classified into two parts: Short-Term Capital Gains (STCG) and Long-Term Capital Gains (LTCG). Both these gains have different tax rates based on different time frames as per asset classes.

For example, for listed bonds, STCG is applicable as per your tax slab if you sell your bonds within 12 months. On the contrary, for unlisted bonds, the same duration is 36 months. If you sell your investments after these periods, they attract long-term capital gains. The LTCG on listed and unlisted bonds is 10% and 20%, respectively, without the benefit of indexation unless you have invested in government-issued Capital Indexed Bonds or Sovereign Gold Bonds.

In this article, we will take a look at the applicable tax implications on different government and corporate bond categories.

Understanding Taxation of Bonds in India

Investing in bonds is a reliable way to earn stable and predictable returns, but it’s equally important to understand the tax rules that apply to these earnings. Whether you earn interest or make a profit by selling the bond, you may need to pay taxes on those earnings. This is called the taxation of bonds.

In India, taxes on bonds can vary depending on the type of bond, whether it is government-issued, corporate, listed, or unlisted, and the duration for which you hold them. Some bonds offer tax benefits, such as tax-free government bonds or Section 54EC capital gain exemption bonds.

Understanding tax on bond returns is important for managing your investments smartly. If you ignore taxes, you might end up with lower real returns than expected. Hence, before investing in bonds, always check how the bond taxation in India applies to your selected instrument. This helps you pick options that are not only suitable for your goals but also efficient from a tax point of view.

What are Government Bonds?

Government bonds are debt instruments issued by the Indian government, either by the central government or state governments. When you buy a government bond, you are lending money to the government. In return, you receive interest income at regular intervals (usually annually or semi-annually), and the full principal amount is paid back at maturity.

These bonds are considered safe, as they are backed by the Government of India. They are suitable for investors who want fixed income with low risk. Examples include Government Securities (G-Secs), Sovereign Gold Bonds (SGBs), and tax-free government bonds issued by public sector undertakings like NHAI or REC.

Some government bonds also provide tax advantages. For example, SGBs offer tax-free capital gains if held till maturity, and tax-free bonds provide interest that is completely exempt from income tax. These tax benefits and safety features make government bonds a preferred option for long-term, risk-averse  investors.

Tax Implications on Government Bonds

There are three popular bonds categorized under government-issued bonds as below.

Government bonds in India offer stable income, but like all investments, they have tax rules you need to be aware of. The tax on bonds in India depends on the type of bond and how long you hold it.

• Interest income from most government bonds (like G-Secs) is taxed as per your income slab. So if you’re in the 20% or 30% tax bracket, that rate applies to your interest earnings.

• If you sell your bonds before 12 months (for listed bonds), you will pay short-term capital gains (STCG) tax, which is also charged according to your tax slab.

• If you hold listed bonds for more than 12 months, the profit will be considered a long-term capital gain (LTCG) and taxed at a flat rate of 12.5% without indexation.

• For unlisted bonds, LTCG applies after 36 months, and the tax is 20% with indexation benefits.

Sovereign Gold Bonds (SGBs) have special rules:

• If held till maturity (8 years), capital gains are completely tax-free. However, if you sell them early, capital gains tax applies based on how long you held them.

• Being aware of these bond taxation rules helps you decide the right time to sell and how to plan your investments more tax-efficiently.

Government Securities (G-sec) Bonds

G-Sec bonds are debt instruments issued by the government. The interest you earn on this bond is treated as per your tax slab. The STCG and LTCG timeline works the same as we described above. LTCG on listed G-sec is charged at 10% and for unlisted at 20% (with indexation benefits). STCG is again charged as per the applicable tax slab.

Sovereign Gold Bonds (SGBs) 

These bonds are issued by the RBI, and the denomination is in grams. SGBs provide you tax exemption and return on your investments along with the value appreciation of gold.

By investing in SGB, you not only get the benefit of investing in gold but also earn a 2.5% return. If you sell your physical gold, you pay 1% TDS, but for SGB, it is 0. Also, the return you receive on investing in this bond is tax-free if you stay invested for the entire 8 years of maturity.

SGBs have a lock-in period of 5 years. If you sell the bond after 5 years, 20% LTCG tax is applicable with cess minus indexation benefits. While if you sell the bonds before 3 years in the secondary market, STCG tax will be applicable as per your tax slab. There is no tax if you hold the bonds for 8 years, which is the maturity term. 

Zero Coupon Bonds

Zero coupon bonds are issued by both government entities and corporations, too. These bonds do not pay you any interest but are issued at a huge discount. So, you basically invest in these bonds for a lower value and, at maturity, get paid the face value. As there is no interest income, there is no associated tax. However, the capital gain is taxable. For a <12 period, STCG is based on your tax slab. For LTCG, your tax liability is 10%.

Corporate Bonds

Corporate bonds are fixed-income securities issued by companies to raise money for business expansion, working capital, or other financial needs. When you invest in a corporate bond, you are essentially lending money to the company for a fixed period. In return, the company agrees to pay you interest, usually at regular intervals, and return your investment at maturity.

These bonds often offer higher returns than government bonds, but they carry more risk, depending on the company’s financial strength. Like government bonds, corporate bonds are also subject to bond taxation rules in India, including taxes on interest income and capital gains. Understanding the tax on bonds in India helps investors make better decisions when adding corporate bonds to their portfolio.

Tax Implications on Corporate Bonds

In the case of corporate bonds, you will earn a higher return due to the risk involved. The tax liability on the return you gain on these bonds is the same as a G-sec bond. For the capital gains, any gains over 12 months for listed bonds and 36 months for unlisted bonds are charged at 10% and 20%, respectively, as LTCG tax. STCG, on the other hand, is as per your tax slab.

Zero-coupon bonds, as mentioned above, can also be issued by corporations or companies to raise funds for expansion or projects. The tax implications on these bonds remain the same as the government-issued zero-coupon bonds.

Tax Differences: Government vs. Corporate Bonds

Understanding the tax differences between government and corporate bonds can help investors plan more efficiently and reduce their tax burden. Here's a simplified comparison:

Tax-Free Government Bonds and Tax-Saving Bonds

Certain government-backed bonds come with tax exemptions or deductions, offering smart ways to lower your tax liability. Here’s how they compare:

These options are ideal for investors looking to align fixed-income investments with tax planning goals.

The bottom line

There is always a benefit when you hold bonds for the long term, as LTCG is taxed at lower tax rates compared to STCG, especially for listed bonds. Hence, even the government encourages investors to go for the long-term and let their money compound and minimize their taxes. You should invest in these bonds based on your goals and risk profile.

Additional Read - Listed vs Unlisted Bonds in India

Frequently Asked Questions

1. Are corporate bond earnings taxed differently from government bonds?

The tax on bond returns is mostly similar for both corporate and government bonds. In both cases, interest income is taxed as per your income tax slab. For capital gains, the difference lies in the listing and holding period. Listed bonds held for more than 12 months attract long-term capital gains (LTCG) tax at 12.5% without indexation. For unlisted bonds, LTCG applies after 36 months at 20% with indexation. So, while the basic rules are the same, listing and holding periods affect the tax outcome.

2. Is there any maximum investment that can be made in government bonds?

There is no general cap for most government bonds, such as G-Secs or Treasury Bills. However, certain bonds like Sovereign Gold Bonds (SGBs) do have limits. For individuals, the maximum limit for SGB investment is 4 kg in a financial year, while for trusts and entities, it is 20 kg. Some tax-saving bonds, like 54EC bonds, also have a cap, ₹50 lakh per financial year. Always check the specific scheme's guidelines before investing.

3. What is the capital gain tax on tax-free bonds?

While tax-free bonds offer exemption on interest income, they are not exempt from capital gains tax if sold before maturity. If held for more than 12 months (for listed bonds), LTCG is applicable at 12.5% without indexation. If sold within 12 months, the gain is considered STCG and taxed as per your income slab. However, if you hold the bond till maturity and simply receive interest, no capital gains tax applies, as there is no sale involved.

4. Which bonds are tax-free in India?

In India, the most popular tax-free bonds are issued by public sector undertakings like NHAI, REC, IRFC, and HUDCO. These bonds offer fixed interest, and the interest income is completely tax-free under Section 10 of the Income Tax Act. However, if you sell these bonds in the secondary market, capital gains tax may apply. Sovereign Gold Bonds are also tax-free on capital gains if held till maturity, though their interest income is taxable.

5. Are municipal bonds really tax-free?

Some municipal bonds in India may offer tax-free interest, but this depends on government notification. The SEBI-regulated municipal bond market is still growing, and only selected bonds, usually issued for infrastructure development, may qualify as tax-free. Investors should check the specific bond’s tax treatment before investing. While interest may be tax-free in certain cases, capital gains on sale are usually taxable based on the holding period and listing status.

6. Is tax deducted on bond interest income?

Yes. Tax Deducted at Source (TDS) is applicable on interest earned from most bonds, especially corporate bonds and unlisted government bonds. TDS is generally 10% of the interest amount if your PAN is updated with the issuer. However, for listed government securities, TDS may not apply in all cases. You must report the full interest income in your tax return, even if TDS is already deducted, and pay additional tax if applicable based on your income slab.

7. How to calculate capital gains on bonds?

Capital gains on bonds are calculated by subtracting the purchase price (including expenses) from the selling price. The holding period determines whether the gain is short-term or long-term bonds.

8. What are the tax implications of selling bonds before maturity?

Selling bonds before maturity may result in capital gains or losses. Short-term gains (held <36 months) are taxed as per the income tax slab, while long-term gains are taxed at 12.5% without indexation.