By Siddhant Mishra
The markets cheered the Budget announcement of not to tinker with capital gains tax, but a proposal to tax income from market-linked debentures (MLDs) as short-term capital gains has come as a rude shock.
Given that they usually carry a face value of Rs 10 lakh, MLDs are mostly subscribed to by HNIs and family offices. Returns are linked to a particular security or market index, such as G-Secs or the Nifty. At present, these are taxed as long-term capital gains at 10% without indexation — if held for at least 12 months. They are also popular among NBFCs.
MLDs differ from regular non-convertible debentures or NCDs, which come with regular interest payouts, as investors get their returns only at maturity.
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“Given that MLDs mostly carry tenures of three years or less, and part of the returns are linked to market benchmark-related risks that are unlikely to play out, it effectively acts like a fixed-income instrument,” said Anuj Kapoor, MD and CEO (private wealth group and venture capital funds platform), JM Financial.
For instance, say a company issues MLDs at a certain coupon rate maturing in two years. Here, the coupon will be paid upon the condition that the benchmark to which it is linked does not fall beyond a level. If it does, only the principal would be returned with no interest.
Sebi regulations only allow principal-protected MLDs to be issued in India. A September 2011 notification by the regulator mandated issuers of such instruments to have a minimum net worth of Rs 100 crore.
Kapoor said MLDs are close to a Rs 15,000-crore market, and majority of the investments will unwind and shift to direct bonds, debt AIFs, and other tax-free bonds.
Agrees Shalibhadra Shah, CFO of Motilal Oswal Financial Services, saying since returns will now be treated as short-term capital gains, the tax would be levied at the maximum marginal rate of 30% (plus surcharge and cess as applicable) on transfer or redemption.
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“Earlier, these debentures yielded higher post-tax returns than FDs or debt MFs owing to low tax incidence. However, with the incidence of full tax proposed, they may lose flavour as post-tax returns will fall drastically,” said Shah.
The FM, in the Budget, has proposed an amendment to the I-T Act, with the view that tax benefits from such instruments are being grossly abused. Experts feel that despite the objective to plug tax leakages, such stringent measures would lead to MLDs losing their competitive advantage.
“The proposed amendment has a dual effect on taxation of such gains. First, all such gains will be taxed at normal rates. Since most taxpayers investing in MLDs are HNIs, they will be taxed at as high as 39%, vis-à-vis 10.92% earlier. Second, indexation of the cost of acquisition will not be available. This would substantially increase the amount of capital gains and reduce overall returns on investment,” said Rahul Charkha, partner, Economic Laws Practice.
He pointed out that this was disadvantageous to investors who have already invested in such MLDs. “For the sake of clarity, it would be prudent if the proposed tax treatment is made applicable to investments made after April 1, 2023, as against gains arising after that date,” he said, adding that investors agitated by the amendment may seek early redemption and rush to withdraw their investments, creating havoc in the market.