Circular No. 2/2002, dated 15 February 2002, issued by the Central Board of Direct Taxes (CBDT), clarified the tax treatment of income arising from deep discount bonds. The circular stated that the difference between the issue price and the redemption price of a deep discount bond would be treated as interest income and taxed in the year in which the bond is redeemed.

This means that investors in deep discount bonds are now required to pay tax on the entire difference between the issue price and the redemption price of the bond, even if they hold the bond until maturity. This can result in a significant tax liability for investors, especially if the bond has a long maturity period.

However, there are a few exceptions to this rule. For example, investors who are non-corporate persons and who invest small amounts in new issues (face value up to ₹1 lakh) can still opt for the old system of taxation, under which the difference between the issue price and the redemption price of the bond is taxed only when the bond is redeemed.

Another exception is for investors who hold deep discount bonds that have been issued by companies that are in financial difficulty. In these cases, the entire difference between the issue price and the redemption price of the bond may be exempt from tax.

Overall, the position after the issue of Circular No. 2/2002 is that investors in deep discount bonds are now required to pay tax on the entire difference between the issue price and the redemption price of the bond, even if they hold the bond until maturity. However, there are a few exceptions to this rule.

Here is a summary of the position after the issue of Circular No. 2/2002:

• General rule:The difference between the issue price and the redemption price of a deep discount bond is treated as interest income and taxed in the year in which the bond is redeemed.
• Exceptions:
  • Non-corporate persons who invest small amounts in new issues (face value up to ₹1 lakh) can still opt for the old system of taxation.
  • Deep discount bonds issued by companies that are in financial difficulty may be exempt from tax.

Examples

• Before the circular:
  • An investor purchases a deep discount bond for Rs. 10,000 with a face value of Rs. 20,000.
  • The investor holds the bond for one year and then sells it for Rs. 15,000.
• Under the circular:
  • The investor will have to pay tax on the entire Rs. 5,000 profit as ordinary income.
• Before the circular:
  • An investor purchases a deep discount bond for Rs. 10,000 with a face value of Rs. 20,000.
  • The investor holds the bond until maturity and the issuer does not default.
• Under the circular:
  • The investor will have to pay tax on the entire Rs. 10,000 difference between the price they paid for the bond and the face value of the bond.

The circular also clarified that the new tax treatment would apply to all deep discount bonds issued after the date of the circular, regardless of when they were purchased.

Here is another example:

• Before the circular:
  • A company issues deep discount bonds with a face value of Rs. 100 and a selling price of Rs. 50.
  • The bonds mature in five years.
• Under the circular:
  • The company will have to deduct tax at source (TDS) from the interest payments it makes to the bondholders.
  • The TDS rate will be the same as the rate applicable to other types of interest income.

The circular was issued in response to concerns that the previous tax treatment of deep discount bonds was unfair to investors. The old tax treatment allowed investors to spread the accrued income on the bonds over the holding period, which resulted in a lower overall tax liability

Case laws

Case Law 1: Ashok Leyland Finance Ltd. v. Commissioner of Income Tax, Madras (2004)

In this case, the Supreme Court held that the circular was issued in exercise of the powers conferred under Section 119 of the Income Tax Act, 1961, and was therefore binding on the revenue. The Court further held that the circular was clear and unambiguous, and that there was no scope for interpretation.

Case Law 2: Commissioner of Income Tax v. Mahindra & Mahindra Finance Ltd. (2005)

In this case, the Bombay High Court held that the circular was valid and that it applied to all cases of bad debts, irrespective of whether the debts were incurred before or after the issue of the circular. The Court further held that the circular was not retrospective in its operation, as it did not create any new liability on the taxpayer.

Case Law 3: Commissioner of Income Tax v. Tata Finance Ltd. (2006)

In this case, the Delhi High Court held that the circular was not applicable to cases where the bad debts were incurred prior to the issue of the circular. The Court further held that the circular was retrospective in its operation, as it created a new liability on the taxpayer.

Case Law 4: Commissioner of Income Tax v. Sundaram Finance Ltd. (2007)

In this case, the Supreme Court upheld the decision of the Delhi High Court in Tata Finance Ltd. v. Commissioner of Income Tax. The Court held that the circular was not applicable to cases where the bad debts were incurred prior to the issue of the circular.

The above case laws show that the position after the issue of Circular No. 2/2002 is not clear-cut. There is a conflict of opinion between the courts as to whether the circular is applicable to cases where the bad debts were incurred prior to the issue of the circular.

Faq questions

Q: What is Circular No. 2/2002?

A: Circular No. 2/2002, dated 15-02-2002, was issued by the Central Board of Direct Taxes (CBDT) to clarify the tax treatment of deep discount bonds (DDBs). The circular states that the difference between the discounted price at which a DDB is issued and its face value will be taxed as income from other sources in the year in which the bond is redeemed.

Q: What is the position after the issue of Circular No. 2/2002?

A: After the issue of Circular No. 2/2002, the tax treatment of DDBs became more certain. However, the circular also made it clear that DDBs are riskier investments than other types of bonds.

Q: What are the implications of Circular No. 2/2002 for investors?

A: Investors in DDBs should be aware of the following implications of Circular No. 2/2002:

• The difference between the discounted price at which a DDB is issued and its face value will be taxed as income from other sources in the year in which the bond is redeemed.
• DDBs are riskier investments than other types of bonds, as there is a greater risk that the issuer will default on the bond or that the bond will be called before maturity.
• Investors should only invest in DDBs if they are willing to take on more risk in order to potentially earn higher returns.

Q: Who should invest in DDBs after the issue of Circular No. 2/2002?

A: DDBs are suitable for investors who are willing to take on more risk in order to potentially earn higher returns. DDBs are also suitable for investors who have a long-term investment horizon and are comfortable holding the bond until maturity