Budget 2023-24, the last full Budget of the Finance Minister before the General Elections in 2024, contains various interesting tax announcements. Among these, the proposals for granting the concessional tax regime to manufacturing co-operative societies, revised slabs and reduction of the
highest rate of surcharge in the new tax regime, increase in the threshold for presumptive taxation and deployment of Joint Commissioners to expedite the disposal of appeals are a few commendable announcements. However, the proposal to tax the capital gains arising on the transfer of Market Linked
Debentures (‘MLDs’) as Short Term Capital Gains (‘STCG’), regardless of the period of holding these instruments, has been somewhat disappointing.

Before we delve deeper into the tax nuances of the proposed amendment, let us, at the outset, understand what are MLDs.

Background of MLDs

MLDs are primarily non-convertible debentures that do not carry a fixed return. Generally, MLDs are listed securities issued with a maturity period of at least one year. These are hybrid instruments and as the name suggests, carry a return which is based on the performance of the underlying index or security such as gold index, Government securities, equity, etc. MLDs are generally issued on the terms that the applicable coupon rate on MLDs would be paid out at maturity, subject to the performance of the underlying index at a specified level.

The issuance of MLDs is regulated by the Securities and Exchange Board of India (‘SEBI’), the capital market regulator in India. SEBI had issued Guidelines for the Issue and Listing of Structured Products/Market Linked Debentures in September 2011. The said guidelines are applicable to all securities that have an underlying principal component in the form of debt securities as defined by SEBI and where the returns are linked to market returns on other underlying securities/indices. Given that by their very nature, MLDs expose the issuer to market risk, the SEBI Guidelines provide that MLDs can be issued only by an issuer having a minimum net worth of INR 1 billion (~ USD 12.5 million) and with a minimum ticket size of INR 1 million (~USD 12,500).

Tax position so far

MLDs have become popular as an investment mode for High Networth Individuals (‘HNIs’)/family offices of HNIs in the past few years on account of investors being able to take advantage of market returns without directly investing in the asset. Typically, the payout on MLDs is made at the time of maturity and no payments are made during the tenure of the MLD. If the MLDs are transferred or redeemed before maturity, the income on such transfer or redemption was hitherto being taxed under the head ‘Capital Gains’. From an income tax perspective, the appeal for investors lay in the fact that since MLDs are listed securities, these need to be held for only a period of 12 months in order to be classified as long term capital assets, so as to avail a base tax rate of 10% on the Long Term Capital Gains (‘LTCG’). Further, in such cases, no coupon payment was being made to the investor. Had a coupon payment been made to investors at maturity, this interest could have been taxed at the rates applicable to the respective investor, the highest rate being 42.744%.

Proposed amendments in tax treatment

Budget 2023-24, however, seeks to introduce a modification in the manner of taxation of MLDs with effect from 1 April 2023, by introducing a new section 50AA in the Income-tax Act, 1961 (‘the IT Act’). Section 50AA of the IT Act defines MLDs to mean a security, which has an underlying principal component in the form of a debt security and where the returns are linked to the market returns on other underlying securities or indices. Further, any securities which are classified or regulated as MLDs by SEBI are also included in the definition of MLDs for the purposes of income tax.

Going forward, it is proposed to tax the capital gains arising from the transfer, redemption or maturity of MLDs as STCG, regardless of the period for which the securities are held by the investor. As a result, the capital gains on MLDs would be taxed in the hands of the investor at the regular rates applicable to the respective investor, which could end up being as high as 42.744% (in the old tax regime), as against the current tax rate on LTCG of 10% plus applicable surcharge and education cess, taking the sheen away from MLDs. The reasoning for this amendment is provided in the Explanatory Memorandum to the Finance Bill, 2023 which states that MLDs are akin to derivatives, which are taxed at the rates applicable to relevant taxpayer. Accordingly, it is proposed to accord a similar tax treatment in the case of transfer of MLDs by deeming the capital gains as being in the nature of STCG. In this context, it is worth mentioning that in the past, income from Deep Discount Bonds or Zero Coupon Bonds was taxed as capital gains in the event of their transfer before maturity and the payment received on maturity was taxed as interest. Further clarity on this tax treatment was provided by the Central Board of Direct taxes (‘CBDT’) by issuance of the Circular No. 2/2002 dated 15 February 2002.

In addition, the Budget seeks to amend the withholding tax provisions in section 193 of the IT Act. It is proposed to withdraw the exclusion carved out from the applicability of withholding tax provisions to interest on securities issued by a company to a resident in dematerialised form and listed on a
recognised stock exchange in India. Accordingly, with effect from 1 April 2023, any interest payments made to resident investors on MLDs would be subject to withholding tax at 10%.

The amended provisions of section 50AA and section 193 of the IT Act discussed above would apply to existing MLDs as well if investors hold these beyond 31 March 2023. These amendments would especially impact HNIs since MLDs were largely popular within the HNI/Ultra HNI community on account of the large ticket size. One may perhaps see a surge upto 31 March 2023 in the transfer of high value MLDs which have been held by investors for at least 12 months, in order to avail the benefit of the lower tax rate on LTCG, before the new provisions are effective.

Once the above proposals are enacted into the tax law with the passage of the Finance Bill, 2023, the tax arbitrage which was so far available in case of MLDs would be lost and this may diminish the attractiveness of MLDs for investors.

Disclaimer

The views expressed in the above article are the personal views of the authors. This material and the information contained herein is of a general nature and is not intended to address specific issues of any person. Any person acting on the basis of this material or information shall do so solely at his own risk. JMP Advisors Pvt Ltd shall not be liable for any loss whatsoever sustained by any person who relies on
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