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This Article authored by our Founder Shri Mayank Mohanka, FCA, analyses and decodes two significant Budget 2023 amendments pertaining to the Capital Markets namely, (i) New Taxation Scheme of Market Linked Debentures (MLDs) and (ii) TDS on Interest Income on Listed Debt Securities.
"Friends, Debentures or Bonds, as we all know, are fixed interest-bearing debt instruments, and usually invested in by those, who want risk-free fixed income streams on their investment portfolios, irrespective of the movement of capital market indices.
However, what if an investor wants to satiate his/her risk-free appetite of investing in a debt security but with a return linked to the market.
Well Yes, for such an investor, the Market Linked Debenture or more commonly known as an MLD, perfectly fits the bill.
Overview of MLDs
Market Linked Debentures (MLDs) are Debt instruments, regulated by SEBI, and usually listed, whose returns are linked to the performance of an underlying index or security in the market like Nifty, Sensex, Gold Index, Government Security etc. When the underlying index or security does well, the return on MLDs will be high and vice-versa. MLDs are usually issued with a maturity of more than one year.
The modus operandi of an MLD can be understood with the help of an example. Say, a company PQR Limited issues an MLD that carries a varying coupon rate of 8% or 6%, and having a maturity of 14 months.
The company issues this MLD, linked to the market condition that the investor will get the offered coupon rate of 8% if the BSE Sensex does not fall by 25% at the end of the tenure of such MLD and the coupon rate of 6% if the BSE Sensex does fall by 25%. So, the investor will get the varying coupon rates of 8% or 6%, depending upon the market linked condition of BSE Sensex falling or not falling by 25%, at the time of maturity.
MLDs usually come at a face value of Rs 10 lakh each, so these are usually tailer-made for HNIs and Corporates.
Some of the big financial institutions which have offered MLDs in India are Reliance Capital Ltd, Kotak Mahindra Investment Ltd, Motilal Oswal Home Finance Ltd, L&T Infrastructure Finance Company Ltd, Axis Finance Ltd etc.
Existing Taxation Provisions in respect of MLDs
The Market Linked Debentures have become quite popular among the investors, on account of the reason that they are usually listed and for listed securities, section 2(42A) of the Income Tax Act, stipulates the holding period for capital gain purpose as 12 months only and not 36 months as is the case for unlisted securities.
The long-term capital gain on listed debt security with holding period of one year is taxable @ 10% plus applicable surcharge, whereas the short-term capital gain is taxable at the applicable slab rate of the investor.
Also, by virtue of clause (ix) of proviso to section 193 of the Income Tax Act, any interest income arising on a listed debt security, is currently exempt from the requirement of deduction of TDS by the issuing authority of such listed debt security.
Thus, the gain arising on transfer of a listed MLD after a period of one year but before its maturity period, is currently being treated as Long Term Capital Gain, and is subject to the applicable tax rate of 10% plus applicable surcharge, just like any other listed debt security.
However, in cases where the MLD has not been transferred before its maturity and instead has been kept till its maturity, then at the time of redemption, the investor gets back the principal amount plus specified interest (subject to the fulfilment of the market linked condition). This interest income is taxable in the hands of the investor just like any other interest income at the applicable tax slab rate of the investor.
Amendment Proposed in the Finance Bill 2023
The Finance Bill 2023 has inserted a new section 50AA effective w.e.f. 1.4.2023, providing that any gain arising on transfer of MLDs, on or after 1.4.2023, will, by-default, be treated and considered as a short-term capital gain and will be taxable at the applicable tax slab rate of the investor and not as long-term capital gain at a reduced tax rate of 10%.
As the investors of MLDs are usually HNIs or Corporates, and as such the effective tax rate on any gain arising on transfer of an MLD on or after 1.4.2023, will be 30% plus applicable surcharge or 22% plus applicable surcharge in case of corporates opting for new corporate tax regime.
Further the exemption available in respect of TDS deduction on interest income earned on listed debt securities including MLDs, has been discontinued with, by omission of clause (ix) of proviso to section 193, and accordingly, TDS will now be deducted @ 10% on interest income earned on listed debt securities including MLDs, w.e.f. 1.4.2023.
The Explanatory Memorandum to the Finance Bill 2023, specifies the new tax treatment for taxation of capital gains in case of Market Linked Debentures, as under:
“Special provision for taxation of capital gains in case of Market Linked Debentures
1. 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.
2. ‘Market Linked Debentures’ are listed securities. They are currently being taxed as long- term capital gain at the rate of 10% without indexation. However, these securities are in the nature of derivatives which are normally taxed at applicable rates. Further, they give variable interests as they are linked with the performance of the market.
3. In order to tax the capital gains arising from the transfer or redemption or maturity of these securities as short-term capital gains at the applicable rates, it is proposed to insert a new section 50AA in the Act to treat the full value of the consideration received or accruing as a result of the transfer or redemption or maturity of the “Market Linked Debentures” as reduced by the cost of acquisition of the debenture and the expenditure incurred wholly or exclusively in connection with transfer or redemption of such debenture, as capital gains arising from the transfer of a short term capital asset.
4. Further, it is 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 a 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.
5. This amendment will take effect from the 1st day of April, 2024 and shall accordingly, apply in relation to the assessment year 2024-25 and subsequent assessment years.”
Rational for the Amendment
It is pertinent to note here that any gain arising on transactions in Exchange Traded Derivatives (F&O) transactions are treated as Business Profits (Non Speculative) and are taxable as Business Income at the applicable slab rate of the taxpayer.
Thus, the rationale as provided in the Explanatory Memorandum, for treating any gain on the transfer of an MLD as a short-term capital gain and taxing it at the higher rate based on the slab rate of the respective investor, is that an MLD differs from a plain vanilla debt security and is a hybrid instrument combining features of both plain vanilla debt security and an exchange traded derivative and as such should be taxable at the applicable slab rate of the investor, just like the business income.
Absence of Grandfathering Relaxation Must be Revisited
It is imperative to note here that such tax treatment of considering the transfer of an MLD as short-term capital gain in all cases, and taxing the same at the higher tax rate based on the applicable slab of the investor, has been made applicable, even for existing MLDs lying in the portfolio of investors and acquired before 1.4.2023, and no grandfathering relaxation has been proposed in the Finance Bill 2023.
In my humble understanding, the grandfathering relaxation must have been provided in the Finance Bill 2023, in respect of MLDs acquired before 1.4.2023 and already lying in the investment portfolios of respective investors, just as it was provided at the time of making long term capital gain on listed equity shares in excess of Rs 1 lac, taxable by the Finance Act 2018.
In the landmark case of ‘Hitendra Vishnu Thakur v. State of Maharashtra [(1994) 4 SCC 602; AIR 1994 SC 2623] the Hon’ble Supreme Court has laid down the ambit and scope of an amending Act and its retrospective operation and has held that a statute should not generally speaking, be applied retrospectively where the result would be to create new disabilities or obligations or to impose new duties in respect of transactions already accomplished.
Thus, in the absence of any grandfathering relaxation, the proposed treatment of considering any gain on transfer of even those MLDs acquired before 1.4.2023, as short term capital gain, in the newly inserted section 50AA of the Act, will definitely create new obligations and impose new tax in respect of the MLDs transactions already accomplished by the investors and as such is definitely amenable to be challenged before the appropriate appellate forums.
This Article has also been published in Taxmann with the Citation [2023] 147 taxmann.com 80 (Article).
