The government has permitted scheduled banks, including state-owned ones, to issue “zero-coupon bonds” to meet long-term capital requirements, according to the Budget documents.

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At present, only an authorised infrastructure capital company/fund or a public sector company is allowed to issue zero-coupon bonds under Section 2 (48) of the Income Tax Act.

A finance ministry official said for the bondholders tax would not be deducted at source. And for the banks, the implied interest rate on these bonds will be allowed as business expenditure on a “pro-rata basis”. Thus it would be attractive for bondholders and banks to subscribe and sell zero-coupon bonds, he said.

In terms of changes in the I-T Act, section 238 would be amended to include banks in the definition of who can issue zero-coupon bonds. Zero-coupon bonds are issued at a discount to the face value. No interest is paid to bondholders.

At the time of maturity, bondholders will receive the face value of the bond. For example, a bond with a face value of Rs 100 may be issued at Rs 85 for a duration of two years. At the end of the two years, the bondholders will get Rs 100, implying an interest income of Rs 15.

In the pre-Budget memorandum submitted to the finance ministry, banks were seeking permission to issue tax-free bonds to finance long-term projects. This is because their deposits, mostly retail in nature, are of shorter duration. This leads to asset-liability mismatch.

Issuance of bonds of longer nature would have solved this problem and also have brought down the cost of borrowing for banks. With retail depositors having various options to earn returns, banks were finding it difficult to reduce interest rates beyond a certain level for fear of losing deposits.

Previously, long term financial institutions such as IDBI and ICICI Bank were allowed to issue tax-free infrastructure bonds, which they used to refinance long-term projects. But this was discontinued around eight years ago.

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