Taxation of Market-linked Debentures in India (2024)

Introduction

Market-linked debentures (MLDs) have become increasingly popular as investment instruments that offer potential returns based on the performance of an underlying market benchmark. While MLDs provide investors with unique opportunities, there is a need to have a comprehensive understanding of market linked debentures taxation.

In this blog, we will explore the taxation of MLDs in India, changes implemented in the Finance Act 2023 and shed light on key investor considerations.

Taxation Provisions In Respect Of MLDs (Before April 01, 2023)

MLDs have gained significant popularity among investors due to shorter holding periods for being entitled to lower capital gains tax rates. According to Section 2(42A) of the Income Tax Act, listed securities, including MLDs, are subject to a holding period of 12 months for determining capital gains instead of the standard 36 months applicable to unlisted securities. The gains from MLDs with a holding period of 12 months or more are treated as Long-Term Capital Gains (LTCG) and taxed at 10% plus a surcharge.

1. Gains arising on the transfer of a listed MLD after a period of 12 months but before its maturity period are treated as Long Term Capital Gains and are subject to the applicable tax rate of 10% plus applicable surcharge, just like any other listed debt security.
2. In cases where the MLD has not been transferred before its maturity, the investor gets back the principal amount plus interest at the time of redemption(subject to the fulfilment of the market-linked condition). This is the interest income and is taxable in the hands of the investor like all other interest income at the applicable tax slab rate of the investor.

Tax Advantage On MLDs Compared To Plain-Vanilla Debt Instruments

Before April 01, 2023, investors in plain-vanilla debt instruments had to pay tax on the annual interest payouts based on their applicable slab rates. On the other hand, investors in MLDs had the advantage of planning their tax liability by holding the MLDs for more than 12 months, which allowed them to pay a reduced tax rate of 10%. This resulted in MLDs offering a higher post-tax return compared to bank fixed deposits and other plain-vanilla debt instruments like non-convertible debts (NCDs).

Changes In Taxation Of MLDs As Per The Finance Bill 2023

With the implementation of the Finance Bill 2023 presented by Finance Minister Smt. Nirmala Sitharaman, in the Parliament on February 01, 2023, introduced a new section 50AA, effective April 01, 2023. As per this provision, any gains derived from transferring MLDs on or after April 01, 2023, will be automatically classified as short-term capital gains (STCG). Consequently, these gains will be subject to taxation at the applicable tax slab rate of the investor rather than being treated as long-term capital gains and taxed at a reduced rate of 10%. This change has eliminated the previous benefit of a lower tax rate for long-term capital gains on MLDs.

As per the newly inserted section 50AA, the holding period of MLDs will now be irrelevant, and capital gains arising on MLDs will be treated as short-term gain. It is important to note that capital gains on MLDs will now be short-term even if they are held for 36 months or more.

Example To Understand The Taxation Before And After April 01, 2023

Let us take a simple example to understand post-tax returns before and after the tax changes.

• XYZ Ltd. issues MLDs linked to ‘Government Bonds maturing in 2030’ and pays a 9% per annum coupon maturing in 14 months.
• 9% is only givenbecause the ‘Government Bond maturing in 2030’ does not fall 25% in price in the 13^th month.
• If the government bond has fallen 25%, only principal protection is there, and you get no interest.
• Say you invested INR 10 crores in MLDs and sold them before maturity, realizing a gain of 9%, which amounts to INR 1.05 crores.

Assumptions

1. Investor redeemed the MLDs just before maturity.
2. The redemption amount will be a little lower, but for ease of calculation, we assume it to be a round figure.
3. For ease of understanding, expenses related wholly or exclusively to the transfer or redemption of MLDs have been ignored.

Tax Deduction At Source (TDS) On MLDs

Clause (ix) of the Proviso to section 193 of the Income Tax Act provides an exemption from the requirement of deductions of TDS on any interest income arising on a listed debt security. The aforesaid section provides no tax deduction for any interest payable on any security issued by a company where such security is in dematerialised form and is listed on a recognized stock exchange in India under the Securities Contracts (Regulation) Act, 1956.

Finance Minister Nirmala Sitharaman, in the Budget 2023-2024, announced the removal of this exemption from TDS. This is because ‘there is under-reporting of interest income by the recipient due to above TDS exemption. Hence, it is proposed to omit clause (ix) of the Proviso to section 193 of the Act. 4. This amendment will take effect from 1st April 2023,’ read the finance bill.

No Grandfathering Relaxation

It is important to highlight the tax treatment of considering the transfer of market-linked Debts (MLDs) as short-term capital gain in all cases and taxing them at the higher tax rate as per the slab rate of the investor. The implementation is without any grandfathering relaxation for existing MLDs held in investors' portfolios before April 1, 2023. The Finance Bill 2023 does not propose any exemption or special treatment for MLDs acquired before this date.

Consequently, for MLDs acquired before April 1, 2023, any gains resulting from their transfer, redemption, or maturity will also be subject to this provision.

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