Tax-free bonds seen as handy tool for FIs

MUMBAI: The government may be floating tax-free bonds with the aim to offer good returns to savers, but in reality, they have become an instrument to hide losses or puff up profits for institutions such as commercial banks. Fixed Income Money Market and Derivatives Association of India, or FIMMDA, a lobby group which sets the valuation of securities, has designed the formula in such a way that institutional holders can raise the value of bonds by a wide range of 12-33 per cent (the tax which they would have otherwise paid) into the value of the bonds, depending on the coupon.

For instance, if a bank owns Rs 1,000 worth of bonds, it can value those at Rs 1,300 as secondary market trades are rare as most investors hold on to tax-free bonds till maturity.

"The practice isn't illegal. But it can hide losses as the appreciation arising out of the treatment can offset depreciation in other bond investments," said a senior executive from a private sector bank request ing anonymity. Banks, as investors, have an additional advantage: the valuation gain looks attractive.

According to FIMMDA valuation norms, tax-free bonds can be valued for mark-to-market purposes following traded data of similar bonds. In the absence of secondary market trades, the bond can be valued grossing up the tax benefit in the coupon.

For example, the latest tax-free bonds were offering 7.11 per cent with 10-year maturities while the pre-tax returns would be 10.77 per cent, assuming corporate tax rate at 34 per cent.

According to the I-T Act, a tax-free bond holder can deduct the interest income of such securities from profit. But no deduction is allowed in respect of any expenditure incurred for earning tax-free income. This means abank cannot claim tax benefit on the entire coupon. If the tax-free coupon is say, 8 per cent, and the total cost of funds is, say, 6 per cent, the tax benefit allowed was only on 2 per cent and not on 8 per cent.