Budget 2023 deals a body blow to market-linked debentures

“One of the positive aspects of the Budget was to deal a body blow to market-linked debentures (MLDs), which had degenerated to instruments of blatant tax evasion, by taxing the capital gains generated at the rate of short-term capital gains,” Sandeep Bagla, Chief Executive Officer, TRUST Asset Management Company, said.

In the Budget 2023, Finance Minister Nirmala Sitharaman said that it has been noticed that a variety of hybrid securities that combine features of plain vanilla debt securities and exchange-traded derivatives are being issued through private placements and listed on stock exchanges. “It is seen that such securities differ from plain vanilla debt securities,” she said.

To tax the capital gains arising from the transfer or redemption or maturity of these securities as short-term capital gains, the government has proposed to insert a new section 50AA in the Income Tax Act.

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HNIs, family offices hit

Further, it has also proposed to define the "Market linked Debenture" as a security by whatever name called, which has an underlying principal component in the form of debt security and where the returns are linked to market returns on other underlying securities or indices and include any securities classified or regulated as a Market Linked Debenture by Securities and Exchange Board of India.

Vaibhav Gupta, Partner at Dhruva Advisors, said the taxation change for MLDs to short-term capital gains will negatively impact HNIs and family offices.

"The changes in tax rates are more likely to impact investors in MLDs wherein investors were getting the benefit of long-term capital gains rates at 10 percent, which will start getting taxed at the short-term capital gain tax rate from next year, making them less attractive as an instrument for investors, who were in effect doing NBFC lending through these instruments," said Vishal Dhawan, CEO, Plan Ahead Financial Planners.

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Advantage, mutual funds

As per the new provision announced in the Budget, the full value of the consideration received or accruing as a result of the transfer, redemption or maturity of MLDs less the cost of acquisition and expenditure incurred in connection with the transfer or redemption of such MLD, shall be treated as short term capital gains.

“Effectively this means that returns from MLDs will be taxed at higher rates. MLDs have been popular investment products among HNIs and family offices given the preferential tax rate. Given the insertion of the above provision in the IT Act, the attractiveness of MLDs as an investment product will diminish significantly. Mutual funds are likely to benefit given that they continue to enjoy long-term capital gains tax treatment with indexation benefit,” said Vishal Chandiramani, Managing Partner-Products and Chief Operating Officer, TrustPlutus Wealth.

Dummies guide to market-linked debentures

MLDs are of two types – principle protected and non-principle protected. They are issued for a period of 13 months to 60 months and generally require a minimum investment of Rs 25 lakh and more.

Unlike a bond that pays a fixed interest either monthly, quarterly, half yearly or annually, MLDs do not pay any regular income. The income comes only at maturity.

This is how it works: An MLD is linked to some underlying financial security like a stock market index such as Nifty or a 10-year government security paper. As there is no income to be had during its tenure, the gain from an MLD is ascertained at the time of maturity, depending on how its underlying asset has moved.

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A market-linked debenture does not pay any coupon before maturity. On maturity, apart from the initial principal component, there is a pay-off, i.e., a return payable. This pay-off depends on the movement of a security or index, as defined initially in the terms of the MLD.

For example, if the underlying index is Nifty 50 and the terms say X percent of the upside movement of Nifty is payable, then Nifty’s movement decides the return. If the terms say 75 percent of the upward movement of the Nifty 50 is payable, and if the Nifty rises 20 percent from the initial level till the observation date, then 15 percent is the return (non-annualized) over the tenure of the MLD.