The budget does away with tax arbitrage on MLD. The market finds a clever solution

Budget 2023 focused on ending the ‘rewdi’ (subsidy) culture for the wealthy, with new tax measures aimed at high net worth investors. It introduced a tax on premium insurance policies 5 lakhs, brought and set up debt mutual funds under short term capital gains tax 10 crore limit for deduction on capital gains reinvested in a house under section 54 and 54F of the Income Tax Act.

The government also revisited the tax on MLD. These instruments were till now eligible for long-term capital gains or LTCG, (in cases where the investments were held for a period of one year) and hence taxed at only 10%. They are now classified as short term capital gains and taxed at the tax slab of an individual. Yet, the financial services industry now seems to have found a loophole: it has redefined the concept of MLD by completely segregating these debentures from the markets and trying to make returns out of them for LTCG taxation. .

What are MLDs?

MLDs are debt instruments which are linked to an external benchmark like Nifty or Government Bond (G-Sec) index. These debentures do not pay regular interest (coupon). Instead, they pay pre-determined returns if certain conditions are met: for example, if the Nifty rises by 20% over a period of 3 years.

Let’s take Nifty 50 (currently trading at around 18,065) as the underlying index. For example, a principal protected MLD may offer to pay a coupon of 15% if the Nifty crosses 21,600 at the end of its tenure. The MLD issuer enters into a derivative contract to some extent betting on the upward movement of the market in order to generate higher returns. If the condition is not met, only the principal amount will be paid by the issuer. If the condition is met, the principal amount along with interest is repaid. In most other types of MLD however, the conditions were defined to meet the goals. Investors can receive both principal and interest while paying less taxes.

These debentures were taxed at 10% (long-term capital gains tax) when sold after a holding period of 1 year. However, this was treated as a loophole by the government and hence, Budget 2023 stated that gains on such MLD would be treated as short term capital gains (irrespective of the holding period). In fact, these gains are now taxed at the slab rate of an individual investor.

According to a study on MLDs written by Aanchal Kaur Nagpal and Shreya Masala of Vinod Kothari Consultants in January 2021, some MLDs in the past were issued only to gain regulatory arbitration. The study noted that the downside condition on which the coupon rate was based was highly unrealistic. “An example where the value of Nifty or G-Sec would fall by 50-75% – in this case a 0% return were to be paid – seems quite improbable. So in almost all situations, the investor will always receive a coupon And the hedging thus shown was a fraud. The MLDs were, thus, not market linked at all, thereby defeating the purpose of introducing these instruments,” highlighted the study.

new hole

MLD, as defined by Budget 2023, is a debt instrument linked to a market or external security. As per the budget memorandum, MLDs are those securities which have an underlying principal component in the form of debt security and where the returns are linked to the returns of the market or other underlying securities or indices. However, returns from these instruments linked to benchmarks other than the above are outside the definition laid down by the Budget. And this is where the loophole comes out. Some companies are now looking to attract high net worth investors by issuing debentures that are not linked to market returns. Instead, they are linked to companies’ internal metrics such as net worth or other such benchmarks. And this is expected to be extremely beneficial for the investors, as 10% LTCG tax benefit can be availed on the investment.

An example of this is the recent issue of debenture pricing. 25 crores on private placement basis by Lendingkart Finance. The instrument is linked to the net worth and capital flows of the issuer and comes with a base coupon of 2% and a ‘redemption premium’ of 8.5% if the final settlement level is greater than or equal to 60% of the initial settlement level. Here, the initial fixing level is the net worth of the company at the time of allotment of debentures. The final fixing level is approximately its net worth and capital inflow at the time of redemption (15 days prior to the redemption date). In other words, as long as the issuer doesn’t suffer a massive 40% loss in its net worth, the investor gets a return of 8.5%. This makes it almost certain to pay 8.5% for this debenture, similar to a guarantee of only 8.5%.

To be sure, the MLD issued earlier also had such unrealistic contingencies. But new terms in recent issues, such as linking instruments to intrinsic factors such as net worth, make debentures tax efficient. “Think of it like an AT1 bond. Repayment is contingent on the company maintaining a certain capital buffer,” said a person with knowledge of the matter, who did not wish to be named. Note that in case of Lendingkart the base coupon of 2%, which is fixed, will be taxed at the slab rate of the investors.

“We cannot say whether new instruments will be market linked now (since it is linked to internal factors), but capital gains may be eligible for taxation, as some tax notes and opinions that are floating in the industry suggest Granted, it’s still a gray area,” said another industry expert who wished to remain anonymous.

Vishal Chandirmani, Chief Operating Officer, TrustPlutus, said, “For investors subscribing to these issues, the risk is that the government may at any time revise the definition of MLD in the subsequent Finance Act for instruments that are ‘external/market-oriented’. benchmark linked to ‘any form of benchmark/factor’. Only those investors who are willing to take such risk should subscribe to these issues. In the worst case, the redemption premium that the issuer is offering , will be taxed at the slab rate instead of the concessional capital gains tax rate.”

Lendingkart has also cautioned its investors. Its placement memorandum said, “Potential investors are urged to consult their own financial, legal, tax and other advisors to determine any financial, legal, tax and other implications of this investment.” “

Chandiramani said it was too early to comment on whether the new avatar of MLD would be a role model in the industry. “Currently, only a few mid/small players have come up with these tools. Will the big players be comfortable with such issues, we will have to wait and see.” He added.

Zero-coupon bonds?

Zero Coupon Bonds or ZCBs do not pay any coupon (interest). They are issued either at their face value or at a discount to the face value but mature with a fixed premium. Hence your return comes in the form of bond price appreciation at the time of maturity.

Some industry players like Nuwama Wealth sought opinion from auditing firm EY on whether these bonds are MLD. The draft opinion, a copy of which has been accessed by Mint, appears to suggest that they will not fall under the definition of MLD. However, under a 2002 circular of the Central Board of Direct Taxes (CBDT), returns from ZCBs or Deep Discount Bonds are still taxed as interest, said Mayank Mohanka, founder of TaxaReam India and a partner at SM Mohanka & Associates. told.

Investors have to mark-to-market valuation of the returns of such bonds on March 31 every year and pay tax on the returns as interest income, the CBDT circular said. Interest income is taxable at slab rate.

what the experts say

“If the return on the instrument is not fixed and the return is linked to variable factors to be determined in the future, the resulting instrument is similar to a derivative. But if the holder claims long-term capital gains, it is likely that the tax authorities will eventually include such instruments under section 50AA (MLD definition) of the Income Tax Act or similar provisions, which give away tax benefits. . Cyril Amarchand Mangaldas.

“I would be very cautious about innovative financial structures if there is some tax uncertainty or potential tax litigation,” said Firoz Aziz, deputy CEO of Anand Rathi Wealth.