Budget ends tax arbitrage on MLDs. Market finds a clever workaround

Budget 2023 focused on ending ‘revdi’ (subsidy) culture for the rich, with new tax measures aimed at high net worth investors. It introduced a tax on insurance policies with premium above ₹5 lakh, brought debt mutual funds under short term capital gains tax and set a ₹10 crore limit for the deduction on capital gains reinvested in a house under sections 54 and 54F of the income tax Act.

The government also revisited the tax on MLDs. These instruments were hitherto eligible for long-term capital gains, or LTCG, (in cases where the investments were for a period of one year) and so attracted just a 10% tax. They have now been classified as short term capital gains and taxed at an individual’s tax slab. Yet, the financial services industry seems to have now found a loophole: It has redefined the very concept of MLDs by uncoupling these debentures from the markets entirely and attempting to make the returns from these eligible for LTCG taxation.

What are MLDs?

MLDs are debt instruments that are linked to an external benchmark such as the Nifty or the government bond (G-Sec) index. These debentures do not pay out regular interest (coupons). Instead, they pay a pre-defined return if certain conditions are met: for instance, if the Nifty rises by 20% over a 3-year period.

Let’s take the Nifty 50 (trading at around 18,065 currently) as the underlying index. A principal protected-MLD may, for example, offer to pay a coupon of 15% if the Nifty crosses 21,600 at the end of its tenure. The MLD issuer enters into a derivative contract to some extent with the funds raised, betting on the upward movement of the market to generate higher returns. If the condition is not met, just the principal amount will be repaid by the issuer. If the condition is met, the principal is repaid along with interest. In most other types of MLDs though, the conditions were defined to meet the targets. Investors could get both the principal and interest, while paying lower taxes.

These debentures were taxed at 10% (long term capital gains tax) if sold after a 1-year holding period. However, this was perceived as a loophole by the government and, hence, Budget 2023 said that gains on such MLDs will be treated as short term capital gains (regardless of the holding period). In effect, these gains are now taxed at the slab rate of an individual investor.

According to a study on MLDs, authored by Aanchal Kaur Nagpal and Shreya Masalia of Vinod Kothari Consultants, in January 2021, some MLDs in the past were issued merely to gain regulatory arbitrage. The study stated that the downside conditions on which the coupon rate was based were highly unrealistic. “An instance where the value of Nifty or a G-sec would fall by 50-75%—in which case 0% return was to be paid—seems quite impossible. Hence in almost all conditions, the investor would always be receiving a coupon and thus the hedging shown was more of a hoax. The MLDs were, thus, not market-linked at all, thereby defeating the purpose of introducing these instruments," the study highlighted.

The new loophole

An MLD, as defined by Budget 2023, is a debt instrument that is linked to the market or to an external security. According to the memorandum to the budget, MLDs are securities having an underlying principal component in the form of a debt security and where the returns are linked to market returns or other underlying securities or indices. However, the returns from these instruments linked to benchmarks other than the above fall outside the definition put forth by the budget. And that is where the loophole stems from. Some companies are now looking to attract high net worth investors by issuing debentures that are not linked to market returns. Instead, these are linked to the companies’ internal metrics such as net worth or other such benchmarks. And this is expected to be hugely beneficial to investors, as the investment can have an advantage of the 10% LTCG tax.

A case in point is the recent issue of debentures worth ₹25 crore by Lendingkart Finance on a private placement basis. The instrument is linked to the issuer’s net worth and capital infusion and comes with a base coupon of 2% and a ‘redemption premium’ of 8.5% if the final fixing level is greater than or equal to 60% of the initial fixing level. Here, the initial fixing level is the net worth of the company at the time of allotment of the debentures. The final fixing level is its net worth plus capital infusion approximately at the time of redemption (15 days prior to the redemption date). In other words, as long as the issuer does not suffer a huge 40% loss in its net worth, the investor gest a return of 8.5%. This makes the payout of 8.5% almost certain, akin to just guaranteeing 8.5%, for this debenture.

To be sure, MLDs issued earlier have also had such unrealistic contingencies. But the new conditions in recent issues, such as linking the instruments to internal factors such as net worth, makes the debenture tax efficient. “Think of it like an AT1 bond. The repayment is contingent on the company retaining a certain capital buffer," said a person with knowledge of the matter who did not wish to be named. Note that the base coupon of 2% in the case of Lendingkart, which is fixed, will be taxed at investors’ slab rate.

“We can’t say that the new instruments will be market-linked anymore (since it is linked to internal factor), but could be eligible for capital gains taxation, as some of the tax notes and opinions that are floating around in the industry suggest, but it still is a grey area," said another industry expert who wants to remain anonymous.

Vishal Chandiramani, Chief Operating Officer at TrustPlutus said, “for investors who are subscribing to these issues, the risk is that the government can at any time modify the definition of MLDs in a subsequent Finance Act from those instruments which are linked to ‘external/market-linked benchmark’ to ‘any form of benchmark/factor’. Only those investors willing to take such a risk should subscribe to these issues. In the worst case, the redemption premium which the issuers are offering will be taxed at slab rate instead of concessional capital gains tax rate."

Lendingkart, too, had a word of caution for its investors. Its placement memorandum states, “potential investors are urged to consult with their own financial, legal, tax and other advisors to determine any financial, legal, tax and other implications of this investment."

Chandiramani said that it is too soon to comment if the new avatar of MLDs will be a norm in the industry. “Currently, only a few mid/small players have come up with these instruments. Whether the bigger players will be comfortable with such issues is what we have to wait and see." he added.

Zero-coupon bonds?

Zero coupon bonds or ZCBs do not pay any coupons (interest). They are either issued at a discount to their face value or at face value but mature with a certain premium. Hence your return comes in the form of bond price appreciation at the time of maturity.

Some industry players such as Nuvama Wealth sought an opinion from auditing firm EY about whether these bonds are MLDs. The draft opinion, a copy of which Mint has seen, seems to show that they will not fall under the definition of MLDs. However returns from ZCBs or deep discount bonds are still taxed as interest under a 2002 circular from the Central Board of Direct Taxes (CBDT), pointed out Mayank Mohanka, the founder of TaxAaram India, and a partner at S M Mohanka & Associates.

The CBDT circular requires investors to make a mark-to-market valuation of the returns of such bonds on 31 March every year and pay tax on the return as interest income. Interest income is taxable at slab rate.

What experts say

“If the return on the instrument is not fixed and the return is linked to variable factors to be determined in future, as a result of which the instrument is akin to a derivative. But if the holder claims long term capital gains, it is likely that the tax authorities will eventually include such instruments under section 50AA of the Income tax Act (MLD definition) or similar provisions taking away the tax benefit," said Leena Chacko, partner, Cyril Amarchand Mangaldas.

“I would be very careful about innovative financial structures if there is some tax uncertainty or possible tax litigation," said Feroze Azeez, deputy CEO, Anand Rathi Wealth.