Finance Bill and the consequent MLD meltdown

It is one thing to potentially change the tax treatment of an instrument, which, although harsher, gives market participants the advantage of choice.

However, retrospectively changing the tax treatment of an instrument for a past period would have major implications. The higher taxation rule for MLDs applies retrospectively and not prospectively, according to the Finance Bill passed by Parliament recently.

background

MLD is a hybrid instrument where the returns are linked to some underlying market index or variable rate. Prior to the budget announcement, listed MLDs were treated at par with equity shares for the purpose of long-term capital gains (LTCG) taxation.

Thus, in case of MLD, the holding period for capital gains purposes is 12 months, while it is 36 months in case of normal capital asset. Therefore, if a listed MLD is held for at least 12 months, and is transferred or redeemed thereafter, the gain will be taxed as LTCG at the rate of 10%. Hence, MLDs have become quite popular, especially among the high net worth individual (HNI) investor community. Presently outstanding amount of MLD in the market is approx. 46,466 crore, with 22,291 crore has been released in the period January 2022-February 2023.

Eliminating tax arbitrage for MLDs, Finance Minister Nirmala Sitharaman proposed in the Budget this year that capital gains on MLDs would be treated as short-term capital assets, irrespective of the holding period. This meant that even if the tenure of the MLD is 36 months or more, the MLD would still be considered a short-term capital asset. Accordingly, income from MLD will be taxed as per income tax slab rates.

Revised edition

The amended Bill confirms that there will be no grandfathering for market-linked debentures (MLDs) as it specifically provides for grandfathering only for debt-oriented mutual funds.

For example, if an investor has acquired an MLD on April 1, 2022, which is due for redemption on July 1 this year, the returns payable on maturity include 12 months of FY23 and 3 months of FY24. Note that MLDs generally pay income on maturity, with no regular interest during the tenure. However, income is earned during the entire tenure of the instrument.

With the change in law, on July 1, the entire income coming in by way of capital gains will be subject to tax as STCG. Obviously, when the subscriber subscribed to the MLD, he expected post-tax returns taking into account the 10% LTCG. This change in taxation took many investors by surprise.

How issuers are responding:

Issuers have resorted to a variety of methods to mitigate the impact of the amendment, including:

Conversion of MLDs into plain vanilla non-convertible debentures (NCDs) by converting MLDs into plain NCDs, so as to avoid the new tax provision. NCDs offer a fixed rate of interest and have a fixed maturity date. Gains (not the interest amount) on NCDs after holding them for more than 12 months are taxable at 10%, while interest will be charged at tax slab rates and TDS deducted. Early redemption of MLDs, which can be done either by exercise of call option, if provided for in the terms of the issue, or through early redemption/ buy-back, subject to a minimum holding of 12 months (as per SEBI regulations) Subjected to. Doing this before April 1 can still benefit from the old tax rules.

Transfer of MLD from the investor to a group entity of the issuer, such that profits earned up to March 31, 2023 are charged on transfer and taxed in FY23 only as per extant law, except for future income after April 1, 2023 Taxes are to be levied under the new law.

In terms of the prescribed principle, retrospective taxation, as a matter of policy and also as per fiscal principles, is questionable. No taxpayer can be told that his income for FY 2023 will be taxable under a different tax regime than when the income was earned.

Vinod Kothari is the Director and Aanchal Kaur Nagpal is the Manager in Vinod Kothari Consultants.