Tax planning? Try infrastructure bonds

For most investors who are conducting their annual tax-planning exercise, claiming tax benefits under Section 88 of the Income Tax Act means utilising conventional options which include taking insurance and investing in Public Provident Fund and National Savings Certificate.

From the total Rs 100,000 that can be claimed as rebates, the aforementioned avenues account for only Rs 70,000; the balance Rs 30,000 is reserved for investments in infrastructure bonds amongst others.

These investments are in the form of shares/bonds/debentures and are issued by public financial institutions like IDBI and ICICI Bank. Also they are subject to a 3-year lock-in period and any redemption prior to this tenure nullifies the tax benefits claimed at the time of making the investment.

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In case a sale/redemption is made prior to the 3-year period, the tax rebate previously claimed is treated as investor's income for the year of sale.

So how good an option are infrastructure bonds and should investors contemplate using the same.

Let's perform a cost-benefit analysis to answer this question. Unlike small savings schemes that fall under the gamut of Section 88, returns offered by infrastructure bonds are modest at best.

For the purpose of our study let's consider the previous issue of infrastructure bonds by a leading public financial institution. Under the cumulative option, the following two variants i.e. coupon rate 5.50% and 5.64%, respectively, were available:

• Invest Rs 5,000 and get Rs 6,030 after 3 years and 6 months.
• Invest Rs 5,000 and get Rs 6,580 after 5 years.

While the aforementioned scheme is not available at present, we have assumed that a similar one will be made available shortly when the tax-planning season kicks in.

Another assumption is that inflation will continue to spiral northwards as a result investors will be compensated with a coupon rate of 50 basis points above the previous issue.

Hence the first option would carry a coupon rate of 6.00% while it would be 6.14% for the second one.

If the tax benefits for both the options were factored in, the returns on a compounded annualised growth rate (CAGR) basis would be as shown in Table 1.

Table 1: Are they good enough?

*CAGR and adjusted for tax benefit; Using existing tax brackets

Even after assuming a generous 50 basis point hike in the coupon rate which may not fructify, the returns are far from impressive.

Now factor in the loss of liquidity, which is another dampener since liquidating these investments before the 3-year lock-in would imply losing the tax rebates claimed. Barring the tax breaks, one can safely conclude that the infrastructure bonds are far from attractive.

The second option for investors is to pay up their tax liability and invest the balance sum in alternate avenues. Hence an investor, who would have invested Rs 30,000 in infrastructure bonds, will instead incur an additional tax liability of Rs 6,000 or Rs 4,500 depending on his tax bracket.

The balance (Rs 24,000 or Rs 25,500) should be invested in other investment avenues like mutual funds. Returns of some of the top performers across categories have been listed in Table 2.

Table 2: Risky but attractive!

Source: Credence Analytics; Returns are Compounded, Annualised. NAV data as on 29th October 2004

At the outset we would like to state that historical returns (in case of mutual funds) have been compared with future assured returns for infrastructure bonds. Investments in mutual funds are market-linked and not assured; therefore historical returns may not be repeated in the future. But a 3-year period indicates reasonably well, what they are capable of delivering going forward.

Secondly the risks associated with mutual fund investing are exponentially higher vis-à-vis those in infrastructure bonds.

A large number of investors who are habituated to risk-free investing might be unwilling to venture into market-linked products and rightly so. Investments should be governed by investors' risk-appetite and not how attractive the returns are.

However the motive behind investing in infrastructure bonds, i.e. to save taxes, should not be so overbearing that it proves to be an infeasible proposition.

If you are an investor with an appetite for risk; paying the taxes and investing in a well-diversified equity/balanced scheme may not be a bad proposition.

The solution probably lies in striking a balance between the two, i.e. the benefits of an investment avenue that offers assured yet modest returns coupled with tax benefits on one hand and a high risk-high return proposition on the other. Find out where you priorities lie and get invested accordingly.

This article forms a part of the latest issue of Money Simplified - The Definitive Guide to Tax Panning. Click here to download, for FREE, the complete guide.