Interest stripping is a tax planning strategy that can help investors in the high tax bracket to reduce their tax burden. This strategy involves buying a bond just before the `record date' for interest payment (or income interest) and selling it after pocketing the interest. However, there will be some gap between exinterest date and the actual interest payment date. The market prices of all bonds include the accumulated interest till that date. In other words, the market price of bonds will fall after the record date and the quantum of fall will be equal to the interest received by you. This strategy, however, will not work with normal bonds because the interest is taxable and, therefore, it would negate the benefit of short-term capital losses you make using this strategy .
Interest stripping works well with tax-free bonds because the interest is tax free and short-term capital losses booked can be set off against other short-term capital gains. The time is ripe to use this strategy because the interest is due on several tax-free bonds (see table).
However, you need to be careful while executing this strategy Section 94 (7) of the Income Tax Act puts restrictions on such strategies. According to the section, the tax-free interest earned in the middle will be added back to the sales price before arriving at the capital gains in certain conditions To avoid this, you have to buy the security three months before the record date. So, you will have to pur chase the bond and hold it for at least 3 months. If you sell the bond after three months, the price would have fallen and the notional loss made by you can be adjusted against certain other taxable capital gains.
THE RISKS INVOLVED
Buying a bond for three months would mean you are taking a short-ter m gamble in the debt market. If the interest rates rise in the meantime, the price of the bond could come down, negating any gains from the tax arbitrage.You could, however reduce the risk by holding the bond for a longer period. This is because the probability of rates coming down is much higher compared to the rates going up in the next 12 months or so. The 10-year yield is expected to come down by at least 50 basis points from current levels in the next one year.
If you extend the holding period by a little more than one year, you can get two tax-free interest payments (see graph).
Though it is an effective strategy, you need to take some precautions while implementing it. Restrict yourself to bonds with enough liquidity. Buy bonds where the issue size is at least `500 crore to ensure higher liquidity.
Best Tax Saver Mutual Funds or ELSS Mutual Funds for 2015
1.ICICI Prudential Tax Plan
2.Reliance Tax Saver (ELSS) Fund
3.HDFC TaxSaver
4.DSP BlackRock Tax Saver Fund
5.Religare Tax Plan
6.Franklin India TaxShield
7.Canara Robeco Equity Tax Saver
8.IDFC Tax Advantage (ELSS) Fund
9.Axis Tax Saver Fund
10.BNP Paribas Long Term Equity Fund
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