NISM-Series-X-B: Investment Adviser (Level 2) · Taxation of Debt Products

Tax-Free Bonds, Sovereign Gold Bonds and Other Debt Instruments Taxation

Updated 11 October 2026 · Fact-checked

This topic tests how each debt instrument is taxed: whether interest is exempt, whether capital gains arise, and what TDS applies. Tax-free bond interest is exempt, PPF is exempt on all counts, SGB interest is taxable but redemption gain is exempt, NSC and NCD interest is taxable. Match each product to its rule.

Understand Tax-Free Bonds, Sovereign Gold Bonds and Other Debt Instruments

Debt instruments are taxed in three places: when you invest (deduction), while you hold (interest), and when you exit (maturity or sale). Exam questions pick one product and test one of these three points.

Tax-free bonds are issued by government-backed entities. The interest is exempt from income tax in the investor's hands. But if you sell the bond on the exchange before maturity, the gain is a capital gain and is taxable. Listed bonds held for more than 12 months give long-term capital gains. Held for 12 months or less, the gain is short-term. Check the current holding period and rates in your study material.

PPF follows the exempt-exempt-exempt idea. Deposits qualify for the Section 80C deduction (within the overall limit, under the old tax regime), interest is exempt, and the maturity amount is exempt. EPF is similar but has conditions: employee contribution qualifies under 80C, interest is exempt only up to prescribed limits on contributions, and withdrawal before five years of continuous service can attract tax and TDS.

NSC interest is taxable. It is accrued yearly and taxed as income from other sources, but the interest reinvested for the first four years is treated as new NSC investment and can qualify for 80C. Sovereign Gold Bonds (SGB) pay 2.5% annual interest, which is fully taxable. If an individual holds the SGB to redemption at maturity, the capital gain is exempt. If sold earlier on the exchange, the gain is taxable as capital gain.

RBI bonds (floating rate savings bonds) pay taxable interest, with TDS applying above the threshold. Non-convertible debentures (NCDs) pay taxable interest. Sale on an exchange gives capital gains, and listed NCDs are taxed as long-term only if held for more than the prescribed period. Always check whether the question says redemption or sale, because the answer changes.

Key formulas to remember

Tax-free bond interest: Interest = exempt; sale before maturity = taxable capital gain; Exemption applies to interest only, not to gain on sale.
PPF: Deposit (80C) + Interest exempt + Maturity exempt; Called EEE. The 80C deduction needs the old regime and the overall limit.
EPF: Employee contribution (80C) + interest exempt within limits + withdrawal conditions; Early withdrawal before five years of continuous service can be taxable.
NSC: Interest taxable yearly; reinvested interest for first four years qualifies for 80C; Interest for the final year is not reinvested, so no 80C for that year.
SGB: Interest 2.5% p.a. taxable; redemption gain exempt for individuals; premature sale gain taxable; Interest is on the issue price, not the market price.
Capital gain: Gain = Sale price − Cost of acquisition; Applies to sale on an exchange before maturity, subject to current holding period and rates.

How to solve Tax-Free Bonds, Sovereign Gold Bonds and Other Debt Instruments questions

Use the same sequence for any question on tax treatment of a debt product.

1Identify the instrument: tax-free bond, PPF, EPF, NSC, SGB, RBI bond or NCD.
2Identify the stage: investment, interest during holding, or exit.
3If exit, check whether it is redemption at maturity or sale before maturity.
4Apply the rule for that stage: exempt, taxable as other sources, or capital gain.
5Check the investor type, since the SGB redemption exemption is for individuals.
6Check TDS or 80C features if the question mentions them.
7Eliminate options that mix rules of different products.

Quickest way: Product-to-rule matching

When to use it: For definition-style MCQs asking which statement about taxation is correct.

Memorise: Tax-free bond interest exempt; PPF fully exempt; SGB interest taxable but maturity gain exempt; NSC, RBI bond and NCD interest taxable.
Spot the stage word: maturity, redemption, sale or interest.
Pick the option that matches the product and stage.
Reject options that say always exempt or always taxable.

Common mistakes in Tax-Free Bonds, Sovereign Gold Bonds and Other Debt Instruments

Saying tax-free bond sale gains are also exempt
The name suggests everything is free of tax.
Fix: Only the interest is exempt. Sale on the exchange gives a taxable capital gain.
Treating SGB interest as exempt
The maturity gain exemption gets mixed with the interest.
Fix: The 2.5% interest is taxable every year. Only the redemption gain is exempt.
Applying the SGB exemption to premature exchange sale
Students ignore the word redemption.
Fix: The exemption covers redemption at maturity by an individual. A market sale gives a taxable capital gain.
Calling NSC interest exempt because it qualifies for 80C
Deduction at investment is confused with tax on interest.
Fix: NSC interest is taxable. 80C only helps on the amount invested, including reinvested interest in early years.
Assuming EPF withdrawals are always tax free
EPF is grouped with PPF.
Fix: EPF has conditions: service period and interest limits. Check them before choosing.

Worked examples

Example 1

Mr. Rao, an individual, holds a Sovereign Gold Bond of face value ₹1,00,000 issued at ₹1,00,000 and receives interest at 2.5% a year. He redeems it at maturity with a gain of ₹40,000. What is his taxable amount for one year's interest and on redemption?

Show the solution

Interest for the year = 2.5% × ₹1,00,000 = ₹2,500.
SGB interest is taxable as income from other sources, so ₹2,500 is taxable.
Redemption at maturity by an individual gives an exempt capital gain.
So the ₹40,000 gain is not taxable.

Answer: ₹2,500 interest is taxable each year; the ₹40,000 redemption gain is exempt.

Example 2

An investor buys a listed tax-free bond for ₹1,000 and receives ₹80 interest in the year. She sells it on the exchange for ₹1,060 after holding it for more than the long-term holding period. What is exempt and what is taxable?

Show the solution

Interest of ₹80 from a tax-free bond is exempt.
Capital gain = ₹1,060 − ₹1,000 = ₹60.
Sale is before maturity, so the gain is not exempt.
The ₹60 gain is taxed as long-term capital gain at the applicable rate.

Answer: The ₹80 interest is exempt; the ₹60 capital gain is taxable as long-term capital gain.

Exam tips

Always look for the stage word: interest, maturity, redemption or sale.
Treat options with always exempt or always taxable with suspicion.
Remember SGB has two parts: taxable interest, exempt redemption gain for individuals.
Verify the current limits, rates and holding periods in the latest workbook, since tax rules change.
With negative marking, skip an option-heavy question only after eliminating two choices.

Practice questions from Taxation of Debt Products

Tax-Free Bonds, Sovereign Gold Bonds and Other Debt Instruments: frequently asked questions

Is interest on tax-free bonds taxable?

No. Interest on tax-free bonds is exempt from income tax in the investor's hands. A gain from selling the bond before maturity is a capital gain and is taxable.

How are Sovereign Gold Bonds taxed?

The 2.5% annual interest is taxable. For an individual, the capital gain on redemption at maturity is exempt. A sale on the exchange before maturity gives a taxable capital gain.

Is NSC interest tax free?

No. NSC interest is taxable as income from other sources. Interest reinvested in the first four years is treated as fresh investment and can qualify for 80C.

Is PPF fully tax exempt?

Yes, PPF is generally called exempt-exempt-exempt. Deposits qualify for 80C under the old regime, interest is exempt, and maturity proceeds are exempt.