Everything you wanted to know about 54EC bonds
A popular option for saving long-term capital gains tax on the sale of real estate is Section 54EC of the Bonds. Investing in these bonds can help you earn gains of up to 50 lakh per fiscal year through capital gains tax. However, there is a five-year blocking period. It was three years earlier. These bonds bear interest, which is currently 5% and is taxable.
While these bonds are effective in saving tax, there is another option to consider. You have two choices: (a) save long-term capital gains tax by investing in 54EC bonds and lock in your money for five years or (b) pay tax, keep your cash and l ‘invest in avenues with a yield greater than 5 percent.
Let’s compare the returns of these two options.
Suppose, for example, that there are long-term capital gains of 50 lakh taxable, after indexation, if any. A sum of 50 lakh invested in 54EC bonds would yield a defined return of 5% per annum. This coupon / interest is taxable at, say, 30 percent (your marginal rate per slab), ignoring the surcharge and tax for simplicity. So your return, net of tax, is approximately 3.5 percent. On the other hand, if you opt for option (b), you pay a capital gains tax, which is taxable at 20 percent if you ignore the surtax and tax, for the sake of simplicity. After paying the 10 lakh kh tax, your remaining investment is 40 lakh. Now let’s see some options for investing ₹ 40 lakh.
PSU tax-free bonds
As there are no new issues of tax-free PSU bonds and interest rates have relaxed, the yields available in the secondary market are lower than they were previously. For our comparison, we assume a return (i.e. annualized return) of 4.25% for an investment in tax-free PSU bonds. 50 lakh invested in 54EC bonds, compounded at around 3.5 percent per annum, drops to ₹ 59.38 lakh after five years. the 40 lakh, which is the net amount remaining in the case of option (b), invested at 4.25% tax-free, drops to ₹ 49.25 lakh after five years. Therefore, investing in 54EC 5 percent (pre-tax) bonds is a better option than paying the LTCG tax and investing the remaining amount.
Perpetual bonds Banque AT1
There is a negative perception of perpetual bonds after the YES Bank fiasco. The risk factors that came to light after the delisting of YES Bank AT1 have always existed, but kicked in and hit investors. That said, there are some frontline banks like SBI, HDFC Bank, and others that are worth investing in.
The range of yields on AT1 bank perpetual bonds is wide. We assume 7.5% to strike a balance between risk (higher return but higher risk) and reward (lower return but lower risk). A 30 percent tax means a net return of about 5.25 percent. Against 59.38 lakh kh in the case of 54EC bonds, 40 lakh invested at 5.25% increases to 51.6 lakh after five years. Although a little higher than the ₹ 49.25 lakh of non-taxable bonds, it is lower than the ₹ 59 lakh of EC54, with bonds making the latter a better option.
It is not fair to compare investments in bonds with stocks. However, to get some perspective, let’s do a comparison. We are going to talk about the break-even rate now. Let’s say equity gives X percent return over five years, and that’s taxable at 10 percent, which is the LTCG rate for equity for a holding period of more than one year. If 40 lakh invested in stocks generates a return of 9.15% per year before tax, or 8.24% net of tax per year, it increases to 59.4 lakh after five years. Therefore, the break-even rate for 40 lakh kh to surpass ₹ 50 lakh over five years, at 3.5% net of tax, is 8.24% net of tax.
Equity returns are undefined and the break-even rate calculated for this asset class to outperform 54EC bonds is 8.24% net of tax. This is difficult for bonds because it will only be possible for a bond with a lower credit quality compared to a PSU rated AAA. With stocks or a riskier bond not being a fair comparison, it is advisable to save tax and settle for 5 percent when investing in 54EC bonds. One aspect you can keep in mind, however, is liquidity – investment in 54EC bonds is locked in for five years.
The author is a corporate trainer (debt markets) and author