Market-Linked Debentures Investment – Impact of Finance Act 2023

What is Market-Linked Debentures (MLDs)?
Market-Linked Debentures (MLDs) are non-convertible debentures that offer returns linked to a specific market index or benchmark. Unlike traditional fixed-income securities that provide a predetermined interest rate, the returns on MLDs are contingent upon the performance of the underlying index or asset. Here’s a detailed look at their characteristics and how they function:
– Return Mechanism: MLDs typically do not offer regular interest payments like conventional bonds. Instead, their payout is linked to the performance of a specific market index (like the NIFTY, SENSEX) or other benchmarks (like interest rates or commodity prices). The returns are usually calculated based on a formula predefined in the debenture's terms.
– Capital Protection: Some MLDs offer capital protection, meaning that at maturity, investors will at least receive their principal amount back, regardless of market performance. These are often termed as Principal Protected Market Linked Debentures. However, there are also non-principal protected variants where the return of the principal is also linked to market conditions, posing a higher risk.
– Risk and Return Profile: The risk and return profile of MLDs can vary significantly. Principal-protected MLDs are generally considered safer but offer lower potential returns compared to non-principal protected ones, which can offer higher returns but with increased risk, including potential loss of principal.
– Taxation: MLDs are generally taxed as capital gains. The tax treatment depends on the holding period; if held until maturity, they are typically treated as long-term capital gains, which can be more tax-efficient than the interest income from traditional debentures, subject to the prevailing tax laws.
– Suitability: MLDs are suitable for investors who are looking for exposure to equity markets or other benchmarks but with a different risk profile compared to direct equity investments. They are often used by investors who want to diversify their investment portfolio beyond traditional fixed-income instruments.
– Liquidity: Market-Linked Debentures are typically less liquid than traditional bonds. They are generally bought with the intention to be held until maturity, and secondary market trading can be limited.
Investors considering MLDs should carefully evaluate their risk tolerance, investment horizon, and the specific terms and conditions of the debenture issue. Consulting with a financial advisor to understand the nuances of such investments is advisable.

Table of Contents

1. Introduction
2. Introduction to Market-Linked Debentures (MLDs)
3. Categories of MLDs
4. Effect of Amendment in MLD under Finance Act, 2023
5. How taxation of MLDs is different from conventional debt instruments?
6. What about Market-Linked Debentures lying in the portfolio before 01.04.2023?
7. Should investors invest in Market-Linked Debentures?
8. Conclusion

1. Introduction

Investment is a mechanism of utilizing the current financial resources in order to yield higher gains in the future or channelizing the funds in such a way as to increase the value of money over a period of time. The market offers the investors various opportunities to invest; together with stocks and bonds being among the traditional options, market-linked debenture is one such option offering unique opportunities to investors in a single investment vehicle.

Market-linked debentures used to have an edge over the plain vanilla debt instruments. As a result, the investors earned better post-tax returns in comparison to other available instruments. In order to curb such beneficial tax treatment, the government vide Finance Act, 2023 has introduced certain amendments to the taxation of market-linked debentures by inserting a new section 50AA under the Income-tax Act, 1961. The features of market-linked debentures, the changes introduced in the tax provisions of the same and impact of such change on the investment decision of the investor have been discussed here.

2. Introduction to Market-Linked Debentures (MLDs)

The traditional debenture is basically a debt instrument. The returns generated on the same known as interest, are paid at a fixed rate over a set period of time (e.g., quarterly, half-yearly, annually, etc.), regardless of market conditions, thus, providing stability and predictability of returns.

Market-linked debenture (MLD) is a type of debt whose return is tied to the performance of a specific market index. The instruments in which the MLDs invest are not limited to equity, they can range from equity, government bonds, gold, etc. So, the returns are linked to indices in the market viz, Sensex, Nifty 50, Gold Index, etc. If these indices perform well, the returns that the MLDs generate are favorable and if these indices underperform, the returns on the MLDs also reflect that performance, implying that the return on MLDs is determined by the movement in the underlying market index. Thus, the returns on the MLDs vary unlike the traditional debentures.

Also, in the conventional debentures, where one gets the returns at specific intervals, the returns generated in MLDs are accumulated and paid only at the end of the tenure of MLD along with the principal amount. So, one does not get any regular return from MLDs. Hence, such products are not favorable for those who want/rely on their supplemental income i.e., income in addition to the primary source of income.

Previously, MLDs had a face value of Rs. 10 Lakh, making them an attractive investment option only for a specific group of people in a specific economic stratum. Generally, people having a definite corpus or those nearing their retirement or wanting better returns with less risk as compared to pure equity funds, invested in such securities. But from 1^st January, 2023, Securities and Exchange Board of India (SEBI) has reduced the face value of MLDs to Rs. 1 Lakh, making them an approachable investment option for the individuals other than High Net-Worth Individuals (HNIs) also.

3. Categories of MLDs

MLDs are mainly categorized into two types, based on the principal protection feature:

1. Principal protected MLDs: The amount invested by the investor is secured in such types of MLDs, i.e., even if the returns earned by the investor on the capital amount invested are nil, there is security that the principal will be repaid. According to SEBI (Issue and Listing of Non-Convertible Securities) Regulations, 2021, only principal-protected MLDs may be issued in India.
2. Non-principal protected MLDs: The issuing company does not guarantee the repayment of the capital invested by the investor in such types of MLDs. The investor is exposed to market risk; however, the investor also enjoys the benefit of higher return potential as compared to principal protected MLDs. Such MLDs are not prescribed by SEBI and hence, not issued in India.

4. Effect of Amendment in MLD under Finance Act, 2023

4.1 Before Amendment

Until Budget 2023 was passed, MLDs used to be a very attractive investment option among the investors due to the lower tax rate on such instruments. The long-term capital gain on listed debt security (MLD) with holding period of more than one year was taxable @ 10% along with applicable surcharge. The tax on the same being much lower as compared to other debt instruments.

For instance, a debt mutual fund has a gestation period of 3 years, to attract lower long term capital gains tax. Unlike other listed debt instruments, which have a waiting period of 3 years, MLDs could be sold after 1 year and get taxed at a very low rate of 10% along with surcharge. This made it extremely attractive amongst High Net-Worth Individuals (HNIs), who wanted security vis-à-vis the principal as also they wanted to earn at a better rate as compared to the plain-vanilla debt instruments like debentures, derivatives, etc. So, this tax advantage made MLDs very attractive among investors.

4.2 After Amendment

Finance Act, 2023 inserted a new Section 50AA in the Act, from 1st April, 2023 onwards, whereby any revenues (gains) earned from transferring or redeeming MLDs would be classified as short-term capital gains (STCG) and the calculation of the same would be as follows:

Earlier, TDS was not required to be deducted on interest income on listed debt instruments, but as per the Finance Act, 2023, TDS will now be deducted @ 10% on interest income earned on listed debt securities including MLDs w.e.f. 1st April, 2023, thereby resulting in tax deduction at source in the amount of interest income being earned by the investor. Impact of the changes on MLDs as an investment option would be as follows:

• High  Capital Gains Tax
• TDS on Interest

5. How taxation of MLDs is different from conventional debt instruments?

The effect of these amendments would be making MLDs not as attractive as an investment product as they used to be prior to these announcements. Previously, it used to be a safe way to earn better returns than the conventional debt instruments, also allowing the investors to customize their risk-return profile as per their preferences and expectations. Taxing MLDs at the investor’s marginal tax slab rate marks a significant stride towards leveling the playing field with other standalone debt instruments like non-convertible debentures (NCDs), bonds, FDs, and G-secs.

MLDs now stand distinguished as the sole debt instrument where income is consistently categorized as STCG, irrespective of holding duration or the investor’s decision to sell on the secondary market or hold until maturity. Even if investors opt to await the payout date and collect coupons from the issuer, the proceeds will be classified as STCG rather than interest under income from other sources (IFOS), adding a unique twist to their taxation.

6. What about Market-Linked Debentures lying in the portfolio before 01.04.2023?

It’s crucial to highlight that the tax treatment, where the transfer of an MLD is consistently treated as short-term capital gains and taxed at the investor’s applicable slab rate, applies universally. This includes existing MLDs held in investors’ portfolios, acquired before April 1, 2023. Notably, there are no provisions for grandfathering relaxation in the Finance Bill 2023.

7. Should investors invest in Market-Linked Debentures?

MLDs are not risk-free instruments. But investors seeking capital protection must invest in MLDs, as they guarantee at least the principal payback at the time of maturity. MLDs have potential to earn higher returns than fixed deposits or other debt instruments, so individuals who are not only looking for fixed and stable returns, must opt for MLDs. Also, through risk-return dynamics, investors who are ready to take calculated level of risk to enhance their returns through growth assets must invest in MLDs. MLDs offer hybrid exposure to its investors viz, he/she is exposed to every class of asset, thus, offering comparatively stable returns.

Under the new taxation rules, income from MLDs will be taxed at the marginal rate and treated as Short-Term Capital Gains (STCG). Investors can offset any short-term capital losses from the same assessment year or the previous eight assessment years across different asset classes against the STCG from MLDs. This offset allows MLD investors to avoid paying taxes on their MLD STCG.

Furthermore, they can carry forward any short-term capital losses resulting from liquidating their MLDs prematurely for up to eight years and utilize them to offset STCG and Long-Term Capital Gains (LTCG) from other assets. This advantageous set-off feature does not apply to income from NCDs, FDs, and G-secs.

8. Conclusion

The Finance Act, 2023 has somehow caused the demise of the so-called “Market-Linked Debentures”, by taking away the strongest reasons for the attractive component of investing in the said securities viz, tax arbitrage. Prior to the amendment, listed MLDs enjoyed the lower tax benefit of 10% on transfer of the same, if held for a period of more than 1 year; as also not attracting TDS provisions on the interest element earned on MLDs. However, post amendment vide Finance Bill, 2023, the insertion of section 50AA to the Act takes away the incentive of lower long-term capital gain rate of 10% by making it taxable as short-term capital asset at normal slab rates of assessee, irrespective of the period of holding.

Besides this, the applicability of TDS provisions on the interest earned on listed debentures has further deteriorated the demand for MLDs as an investment option. However, the primary benefit of investing in MLDs remains the same owing to the hybrid exposure to various asset classes, allowing an investor to gain from the growth of other markets viz, equity, government securities, etc. without actually investing in them, which keeps it still alive.