Market-linked debentures (MLDs) are a type of debt instrument whose returns are linked to a certain financial index or indices, such as the Nifty 50, the price or yield of a government security, or any other index/basket of stocks. Offered at a tenure of 12-36 months, MLDs provide a return on the principal at maturity. More importantly, they may allow investors to benefit from upward market movements while reducing (albeit not eliminating) the risk associated with directly investing in the underlying asset.
MLDs have emerged as a good option for high-net-worth individuals (HNIs) looking for a fixed-income investment vehicle over the years.
HNIs frequently gravitated towards MLDs in the past because these instruments enjoyed preferred tax status for many years. If they held these listed debentures for more than one year and earned capital gains on them, they were only taxed at 10%. All in all, they earned higher net profits on these instruments compared to many other instruments.
But now, India’s MLD landscape is changing, particularly with respect to MLD taxation.
To many investors, these changes mean that MLDs are no longer an attractive investment vehicle.
But is this necessarily true?
Does the scrapping of MLDs’ non-preferential tax status mean that HNIs and other investors should no longer consider adding MLDs to their investment portfolios?
Let’s take a look.
Market-linked Debentures Taxation: Before and After 1st April 2023
Till March 2023, MLDs held for over a year and generating capital gains were taxed at a flat rate of 10%. Plus, unlike other debt mutual funds, MLDs did not have a gestation period of 3 years to be categorised as a long-term capital asset. They thus provided better post-tax returns than plain vanilla debt instruments and bank FDs. So, it’s unsurprising that many HNIs considered MLDs desirable for their wealth-building portfolios.
In the Union Budget 2023, presented by Finance Minister (FM) Nirmala Sitharaman on 1st February 2023, the tax treatment previously widely followed for MLDs was repealed. From 1st April 2023 onwards, any revenues (gains) earned from transferring or redeeming MLDs would be classified as short-term capital gains (STCG) and taxed at the rate applicable for the investor (also known as the marginal rate or slab rate) instead of being treated as long-term capital gains (LTCG) and taxed at long term capital gain tax rate of 10%. Since HNIs fall in the 30% tax bracket, they should expect to be taxed for their MLD gains at this rate (plus a surcharge). Additionally, the tax deducted at source (TDS) exemption that was previously there for all listed Non-convertible debentures (which was applicable for listed MLDs) has now been removed.
These new rules apply to all MLDs, irrespective of holding period and listing status, sold or matured after 1st April 2023. All these facts together mean that HNIs are unlikely to earn the higher post-tax returns on MLDs that they once did, which is why they – and most market participants – view these changes negatively.
However, there are also some positives in the new taxation regime. Investors should be aware of the negatives and positives to make informed decisions and continue capturing tangible value from their MLD investments.
Market-linked Debentures: Benefits for Investors After 1st April 2023
Investors must guard against developing a myopic view of MLDs simply because the taxation rules have changed. While it’s true that the scrapping of preferential tax treatment can affect the overall returns possible from MLDs, these new rules also create several positives for investors.
For one, taxing MLDs at the investor’s marginal rate brings much-needed parity between MLDs and other standalone debt instruments like non-convertible debentures (NCDs), bonds, FDs, and G-secs. The interest income from these instruments is also taxed at marginal rates. Such parity can simplify tax planning for investors and give them more visibility into the gains they are earning and the tax they are paying. Further, this means there is no additional negative in MLDs compared to other debt instruments to worry about.
Another positive for investors is that MLDs are now the only debt instrument whose income will always be treated as STCG. And this treatment will be applicable irrespective of the instrument’s holding period and whether the investor decides to sell it in the secondary market or hold it till maturity. If they choose to hold it until the payout date and receive the coupon from the issuer, the proceeds will be taxed as STCG and not as interest under income from other sources (IFOS). Such short-term capital gain is taxed at the same rate as interest and allows one to set off any short-term capital losses carried forward from the last 8 financial years.
Since MLD income will now be taxed at the marginal rate and treated as STCG, any short-term capital loss from the same assessment year or the previous eight assessment years from any asset class can now be set off against the STCG arising out of MLDs. With this set-off, MLD investors with these losses pay no taxes against the MLD STCG. They can also carry forward any short-term capital losses incurred by liquidating their MLDs before maturity for the next eight years and set them off against STCG and LTCG from any other asset. This benefit of set-off is not available with income from NCDs, FDs, and G-secs.
All investors must be aware of these potential benefits of the new MLD taxation regime instead of assuming that these rules will put them at a disadvantage and automatically result in losses. After all, knowledge is power. Knowledge is also profits and wealth!
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