Why is grandfathering exemption required in market linked debentures?

MLDs are debt instruments, regulated by the Securities and Exchange Board of India (SEBI), and are usually listed. The MLD return is linked to the performance of the underlying index or security in the market. MLDs were becoming a popular investment avenue before the budget announcement. As listed securities, these instruments enjoyed a shorter holding period of 12 months for determining capital gains as compared to a longer holding period of 36 months applicable in the case of unlisted securities.

After a period of one year but before its maturity, gains arising on transfer of listed MLDs up to March 31 are considered long-term capital gains (LTCG), and are subject to a concessional tax rate of 10%. applicable surcharge. However, in case the MLD is held till maturity, the interest income is taxable in the hands of the investor like any other interest income at the slab rate applicable to the investor. By virtue of clause (ix) of the provision of section 193 of the Income Tax Act, any interest income arising on listed MLDs is presently exempt from the requirement of deduction of TDS (Tax Deducted at Source).

The Budget proposes that any gain arising on transfer of MLD on or after April 1 will be treated as short-term capital gain (STCG), irrespective of the period of holding, and will be taxable at the applicable slab. Not as long-term capital gains at the investor’s rate and a lower tax rate of 10%.

As the investors of MLDs are generally high net worth individuals (HNIs) or corporates, the effective tax rate on any gain arising on transfer of MLDs on or after 1st April is higher of 30% or 22% or 15% Will apply. The surcharge depends on the choice of taxation regime. Any profit arising from transactions in Exchange Traded Derivatives (F&O) is taxable as business income at the applicable slab rate of the investor. The rationale provided in the Explanatory Memorandum for treating any gain on transfer of MLD as STCG and taxing it at a higher rate based on the slab rate of the investor is that an MLD is different from a plain vanilla debt security and the plain Vanilla is a hybrid instrument combining the features of both a debt security and an exchange traded derivative and thus should be taxable at the applicable slab rate of the investor in the same manner as trade income.

With effect from April, the exemption available in respect of tax deducted at source on interest income earned on listed debt securities has also been discontinued as the Budget has fixed 10% TDS on listed company bonds. But since any gain on transfer/redemption/maturity of MLD will be taxed as STCG, and TDS is not normally deducted on such gain, the tax department should give a suitable clarification in this regard.

It is important to note here that such tax treatment of treating transfer of MLD as STCG in all cases, and taxing the same at the applicable slab rate of the investor, has also been made applicable to existing MLD lying in the portfolio. of investors and acquired before April 1, and no grandfathering exemption has been proposed in the Finance Bill 2023. A grandfather clause is defined as the part of a new rule or law that does not apply to a particular group of people, allowing them to continue following the old rule or law.

The absence of grandfathering protection could result in liquidity issues in the bond market segment as existing investors would call for their premature redemptions, to ensure that the specified deadline of April 1 is not violated. Any retrospective/retrospective amendment is generally not viewed in a good light by the judiciary and thus this budget amendment can definitely be challenged before the appropriate appellate forums.

The government should consider providing much-needed grandfathering exemption in respect of MLDs acquired before April 1 and lying in the investment portfolio of investors, as provided at the time of making long-term capital gains in excess of listed equity shares. Of 1 lakh, taxable by the Finance Act 2018. Clarity is also required on the method to be adopted for determining the cost of acquisition of MLD and the date of transfer i.e. FIFO (First In, First Out) or Weighted Average method. The purpose of its STCG calculation.

Mayank Mohanka is the founder of TaxAaram India and partner of SM Mohanka & Associates