👍👍👍*Tax market-linked debentures carefully | The Financial Express

Clipped from: https://www.financialexpress.com/opinion/tax-market-linked-debentures-carefully/2981703/

The Finance Bill 2023 proposes to tax the gains from these as short-term capital gains, irrespective of period of holding. Although it seems like a prospective amendment at the first glance, it will have retrospective effect

The Finance Bill 2023 (FB 2023) has proposed an inconspicuous amendment in taxation of MLDs. (IE)

By Drushti Desai and Ushma Shah

In the evolving world of financial products, market-linked debentures (MLDs) had gathered great momentum. These are securities which have an underlying principal component in the form of a debt security, and returns are linked to the market returns on other underlying securities or indices. Many large financial services intermediaries have issued such products. These are listed on the stock exchanges in India.

It is pertinent to note here that these MLDs would typically have a protected principal amount and the embedded derivative component would be based on index/listed securities/government securities, etc. These are floated by the financial intermediaries who, in turn, use part of the proceeds to write the debt financing instruments of corporates. This protects the capital to be repaid to the investors. On the back of the underlying debentures, MLDs would derive its specific rating.

The Sebi Regulations that govern these require the issuer of MLDs to report the value of these instruments as assessed by a credit rating agency on a weekly basis, at the minimum. The minimum ticket size of investment is mandated at Rs 10 lakh. Hence, these are instruments where only the high net-worth individuals (HNIs) park their funds. They are typically marketed as capital-protected instruments with returns having upside linked to market performance. Thus, the portion of the MLD investment proceeds that are floating would find its way into market based instruments, which would give them the market based returns.

The Finance Bill 2023 (FB 2023) has proposed an inconspicuous amendment in taxation of MLDs. The amendment simply says that the gain on these instruments would be taxed as short-term capital gains. Let’s dive deep into what this means for the investors of these MLDs.

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Based on the existing regime, the anticipated likely tax, at the time of their issue, would have been considered at 10% on the gain that would be earned on these instruments, since these listed instruments would become long term with only one year of holding period. FB 2023 proposes to tax MLD as short term capital gain(“STCG”) irrespective of the period of holding.

In the context of STCG it can be noted that, certain listed securities, such as equity share in a company or a unit of an equity oriented fund or a unit of a business trust enjoy a lower rate of STCG, viz. at the rate of 15%, provided the transfer is charged to securities transaction tax (“STT”). Memorandum to FB 2023 explains that as these securities are in the nature of derivatives, and derivatives are taxed at applicable rates, this amendment would align the tax on MLDs with tax on derivatives. Clearly, the return that the instrument earns is hybrid, i.e., market-based and on the underlying debt instruments. Even if one were to look at debt oriented balanced funds, these instruments have still been given differential treatment compared to such mutual funds.

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It may be noted that, while STCG tax on listed equity shares or equity oriented funds or units of business trust is chargeable at 15%, MLDs would be taxed at the maximum marginal tax rate. Thus, an individual with taxable income in the highest tax bracket will now pay tax on this income at 30% under the proposed amendment compared to 10% applicable earlier. This amendment could likely deter people from investing in MLDs and influence them instead to directly invest in the underlying instruments or invest in mutual funds. If the investors take a direct exposure in underlying instruments, there will have to be a trade-off between the downside risk of losing the principal vis a vis a 20% additional tax on capital gains.

This amendment, if passed, will apply to all MLDs transferred or redeemed after April 1, 2023. Although it seemingly looks like a prospective amendment, it is indeed a retrospective change, since it applies to these structured instruments that are already issued and invested.

Considering that MLDs are linked to underlying debt issue, an early exit to the holders by way of redemption may not be feasible. Also, it may be noted that though these MLDs are listed, majority of them are not traded in the secondary market over the exchange, making them illiquid. Thus, though this amendment would apply to MLDs transferred or redeemed after April 1, 2023, an early exit for the investor seems difficult. This would affect the perceived after-tax returns for the investors, who may not have fully understood the nuances of the instruments. Ideally, relief could given to the investors by applying the proposed provisions only to issuances after April 1, 2023, thereby, making this amendment truly prospective.

Writers are partners, Bansi S Mehta & Co.