The Lok Sabha on 24 March cleared the Finance Bill, 2023, with several amendments. However, what has been a matter of grave concern for investors is that it denied them the benefit of a much-expected grandfathering for market-linked debentures (MLDs).
It is one thing to prospectively change the tax regime of an instrument, which, however harsh, allows market participants the benefit of choice.
However, changing the tax treatment of an instrument for the period already gone by amounting to a retroactive change will have huge implications. Going by the finance bill passed in the parliament recently, higher taxation rule for MLDs is applicable retrospectively and not prospectively.
The background
MLDs are a hybrid instruments where the return is linked to some underlying market index or variable rate. Before the budget announcement, the listed MLDs were treated at par with equity shares for the purpose of long-term capital gains (LTCG) taxation.
Thus, in the case of MLDs, the holding period for capital gain purposes is 12 months, as opposed to 36 months in case of normal capital assets. Therefore, if a listed MLD is held for at least 12 months, and transferred or redeemed thereafter, the gain will be taxed as LTCG with a rate as low as 10%. Therefore, MLDs became quite popular, especially among the high net-worth individual (HNI) investor community. Currently, the outstanding amount of MLDs in the market is approximately ₹46,466 crores, with ₹22,291 crores issued in January 2022-February 2023 period.
Ending the tax arbitrage for MLDs, finance minister Nirmala Sitharaman proposed in the budget this year that irrespective of the holding period, capital gains on MLDs will be taken as short term capital assets. This meant that even if the tenure of the MLDs is 36 months or longer, the MLDs will still be treated as short-term capital assets. Accordingly, income from MLDs will be taxed as per income tax slab rates.
Amended version
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 MLDs, on 1 April 2022, which is due for redemption on 1 July this year the returns payable on maturity include 12 months’ of FY23, and 3 months of FY24. Note that, income on MLDs is usually payable on maturity, with no regular interest during the tenure. However, the income is earned throughout the tenure of the instrument.
With the change of law, the entire income, coming by way of capital gains on 1 July will be subject to tax as STCG. Obviously, when the subscriber subscribed to the MLDs, he expected a post-tax return, taking 10% LTCG into consideration. This change in taxation takes many investors by surprise.
How are issuers reacting:
Issuers have resorted to various means to minimize the ramifications of the amendment including:
Converting the MLDs to plain vanilla non-convertible debentures (NCDs) by changing in the terms of the MLD to plain NCDs, so as to escape the new tax provision. NCDs offer a fixed interest rate and have a fixed maturity date. Gains on NCDs (not the interest amount) is taxable at 10% after holding it for more than 12 months while the interest would be charged at tax slab rates and TDS deduction. Early redemption of MLDs, which can be done either by exercise of call option, if provided in the issue terms, or through early redemption/ buy-back, subject to a minimum 12 month holding (as per Sebi regulations). By doing so before 1 April , one can still benefit from older tax rules.
Transfer of MLDs from the investor to a group entity of the issuer, such that the gain accruing till 31 March 2023 gets realised on the transfer and taxed in FY23 itself as per the existing law, leaving only the future accrual of income after 1 April 2023 to be taxed as per the new law.
As a matter of settled principle, retrospective taxation is questionable, both as a matter of policy, as also as per fiscal principles. No taxpayer can be told, in hindsight, that his income for FY23 will be taxable under a different tax regime than the one that prevailed when the income was earned.
Vinod Kothari is a director and Aanchal Kaur Nagpal is a manager at Vinod Kothari Consultants.