Background
It is common for corporates and financial institutions to invest in debt instruments in order to earn risk free/low risk returns. In cases where the debt instruments are acquired in secondary markets, the acquisition of the security may entail payment of principal, unpaid interest and premiums. The deductibility of unpaid interest (colloquially referred to as ‘broken period interest’) has been a litigious issue in India.
The recent judgment of Supreme Court of India in Bank of Rajasthan[1] has put to rest the controversy with respect to taxation of broken period interest in the context of investments made by banks in government securities to maintain the statutory liquidity ratio. However, the taxability of broken period interest for other taxpayers is far from settled.
Before delving into the intricacies of broken period interest taxation, let us understand the practical intricacies involving payment of broken period interest. Let us consider non-convertible debentures (‘NCD’) as underlying security carrying a fixed coupon rate which is redeemable post the expiry of a predefined period as per below details:
Face value of NCD = INR 100
Annual interest on NCD payable every year on 31 March = INR 12 annually
Date of purchase of NCD= 30 September
Accrued interest on NCD (1 April to 30 September) = INR 6
Purchase price of NCD = INR 107 (inclusive of INR 6 as accrued interest and INR 1 as premium paid for purchase of NCD)
Redemption Price of NCD at year end = INR 110
In the aforesaid example, the taxpayer purchased NCD on 30 September. Thus, it must pay the seller the accrued interest (INR 6 in above example) along with the face value of NCD. This accrued interest, which is broken period interest.
The moot issue here arises is whether broken period interest paid will be allowed as an expense to offset the interest income earned by the investor.
Existing jurisprudence on broken period interest
Up to 1 April 1989, interest on any security issued by the Central or State Government was required to be offered to tax as ‘interest on securities’ under erstwhile Section 18 of the Income-tax Act, 1961 (‘Act’) against which corresponding expense incurred to realize interest income were allowed as deduction[2]. In reference to the erstwhile sections, the SC in case of Vijaya Bank[3] held that the price paid for the securities (including the broken period interest) was in the nature of a capital outlay and no part of it can be set off as expenditure against income accruing on those securities.
Section 18 of the Act was subsequently omitted by the Finance Act, 1988 with effect from 1 April 1989. Pursuant to the omission of Section 18, the income from securities can either be taxed under the head capital gains, income from other sources or business income depending on the intent with which the security has been acquired.
When the securities are held as stock-in-trade, Bombay HC in the case of American Express International Banking Corporation[4] has held that broken period interest is allowable as deduction while computing business profits. The Court also distinguished Vijaya Bank’s ruling (supra) on the basis that its ratio is not applicable when interest income is assessed as business income. The said Bombay HC judgement was also upheld by the SC in the case of CitiBank NA[5].
Relying on the abovementioned judgements, the SC in the case of Bank of Rajasthan (supra) elucidated the fact that it is the intention of the security holder which shall determine the taxability of broken period interest, i.e., if the securities are held as stock-in-trade, deduction on broken period interest shall be allowed as business expense. Whereas, if the securities are held as investment, the SC held on one hand that the benefit of broken period interest will not be available. On the other hand, the SC judgment seems to suggest that such broken period interest will be added to cost of acquisition of security where it is not held as a trading asset which has led to further controversies in taxation treatment of broken period interest where securities are held as investments.
Though, the SC has not dealt into the aspect of when can a security be classified as a trading asset, in order to undertake the said classification, one may refer to principles enunciated in Circular No. 4 dated 15 June 2007 issued by the Central Board of Direct Taxes.
Seemingly, the deduction for broken period interest paid on acquisition of securities held as stock in trade has been settled. However, one may ponder if the interpretation of the Supreme Court for taxability of government securities held as investment will also be applicable for NCDs when the characterisation of the income on its sale as well as redemption is in itself debatable.
The ‘unsettled’ issue around the potential overlap of income arising from redemption of debentures under two heads of income, viz. capital gains or income from other sources was recently expounded by the Bombay bench of ITAT[6]. In the said case, the ITAT held that the income from redemption of NCDs should be taxed as interest from securities. However, if the NCDs are sold in an open market, the difference in value of market price and face value would amount to capital gains.
In a case where even the redemption of debt instrument is taxed as interest income, one may ponder whether deduction of broken period interest can be offset against the said income even if the debit instrument was held as a capital asset. However, reconciling the said proposition to the judgment of SC in case of Bank of Rajasthan (supra) could be challenging.
Also, the conclusion that a mere difference in the mode of monetising from NCD will lead to a change in characterisation of income is also questionable.
Conclusion
While the Supreme Court has further clarified that the intention of the security holder will be the determining factor for allowability of broken period interest, the question of deductibility still remains open for securities held as investments. This is because the very character of income from sale/ redemption of certain securities is a matter of debate.
Further, irrespective of characterisation in books of the taxpayer, the borrower may deduct tax at source on the premium on redemption, ignoring the broken period interest, which may lead to certain mismatch in the income offered to tax by the taxpayer vis-à-vis the income on which tax is deducted. It would be interesting to see how the matter pans out before higher judicial forums for characterisation of income for securities held as investments.
[The authors are Partner, Principal Associate and Senior Associate, respectively, in Direct Tax Team at Lakshmikumaran & Sridharan Attorneys]
[1] Bank of Rajasthan v. CIT, [2024] 301 Taxman 463 (SC)
[2] Erstwhile Section 19 of the Act
[3] Vijaya Bank v. Commissioner of Income-Tax (Additional), [1991] 187 ITR 541 (SC)
[4] American Express International Banking Corporation v. CIT, [(258 ITR 601) (Bom.)]
[5] CIT v. Citi Bank NA, Civil Appeal No. 1549 of 2006
[6] Kushaal C. Thackersey v. ACIT, TS-293-ITAT-2024(Mum)
