Tax-free bonds can provide returns that are higher than the prevailing interest rates offered by banks.
The corporate affairs ministry has said tax-free bonds providing more yield than prevailing bank rates would not violate provisions of the Companies Act.
The ministry has provided clarity on the matter at a time when many entities, including the Railways, are looking to raise funds by way of issuing tax-free bonds.
"In cases where the effective yield (effective rate of return) on tax-free bonds is greater than the prevailing yield of one year, three-year, five-year or ten-year government security closest to the tenor of the loan, there is no violation of... Companies Act, 2013," it said in a circular issued on Thursday.
Earlier this week, Finance Minister Arun Jaitley said the proposal to allow railways and highways to issue tax-free bonds has been cleared.
"I today cleared a proposal for both (highways and railways) these sectors to have a large investment by way of tax-free bonds," he had said.