How is income from MF segregated portfolio taxed?

With an increase in defaults or downgrades of debt instruments, debt mutual funds have been resorting to side-pocketing of such instruments to ensure that the whole debt portfolio is not impacted by such incidents.

Of late, a few corporates such as Vodafone Idea and Zee Learn, whose instruments had been earlier segregated by mutual fund schemes, paid interest or repaid principal on bonds. The proceeds received by the AMC (asset management company) is transferred to the unitholders of the scheme.

Here, we look at how the proceeds from such segregated portfolios will be taxed.

Segregated Portfolio

When a particular instrument in a debt portfolio defaults on interest or repayment, or faces downgrade by credit-rating agencies, the AMC may segregate such instruments from the rest of the debt fund’s portfolio. This is done so that the NAV of the entire portfolio is not impacted by the credit/default incident. This process is called ‘side-pocketing’.

After the side-pocketing, the ‘segregated portfolio’ comprises debt or money market instruments affected by the credit event or default. The debt portfolio excluding the segregated portfolio will be considered as ‘main-portfolio’, in which you will continue to have the number of units you purchased. 

On the day of side-pocketing, the existing investors in the scheme will be allotted an equal number of units in the segregated portfolio as held in the main portfolio.

For example, assume you invested in scheme ‘A’ that segregated its portfolio on April 15, 2020. In scheme ‘A’, say, you bought 100 units (@ ₹ 7 per unit) in January 2017, 200 units (@₹ 9 per unit) in January 2018 and 300 units in January 2019 (@₹ 11 per unit). In total, you own 600 units in the scheme at an acquisition cost of ₹ 5,800.

Now, on April 15, you will be allotted 600 units in the segregated portfolio by the AMC, so that you have 600 units each in the segregated portfolio and main portfolio.

No redemption and subscription shall be allowed in the segregated portfolio. Whenever the entity – that issued the default/credit-affected instrument – pays the interest and repays the principal, the AMC pays back to its unitholders. When this happens, the units owned by the investor in the segregated portfolio will be extinguished to a certain extent.

When units extinguish, the transaction is covered under the definition of ‘transfer’ in the Income-Tax Act for the purpose of capital gains and tax is levied.

For the computation of capital gains, three factors are important – the cost of acquisition and sale proceeds that determine the gain/loss on investment; and the period of holding, which determines whether it is a short- or long-term capital gain.

The Budget 2020 has amended the Income-Tax Act, 1961 to provide clarity with regard to the tax treatment of capital gains from the segregated portfolio.

Period of holding

The amended IT Act implies that the period of holding of segregated units should be from the day the original units in the main portfolio are purchased.

In our example, where there is a segregated portfolio of 600 units, 100 units will be considered to be held from January 2017, 200 units from January 2018 and 300 units from January 2019 – the same as how the units in the main portfolio are treated.

Thus, the date of side-pocketing or the date of segregation does not matter.

If the units are held for a period of less than 36 months, short-term capital gains (STCG) arise, which will be added to your income and will be taxed as per your income-tax slab rate. In case of holding for three years (36 months) or more, the gains are treated as long-term capital gains (LTCG) and are taxed at 20 per cent with indexation benefit.

In our example, say, on May 30, 2020, the AMC paid and settled proceeds with respect to units in the segregated portfolio. While LTCG arises on the first 100 units (since held for more than three years), STCG arises for the next 500 units.

Sometimes, the AMC may repay the amount at various instalments. For instance, in case of Franklin’s segregation of Vodafone instruments, the fund house initiated processing the payments twice. First on June 13, 2020 and later on July 10, 2020. On first repayment, only some units of investors in the segregated portfolio were exhausted and with the second instalment, all the remaining units were exhausted.

In such cases, the period of holding of units exhausted shall be calculated as per FIFO basis.

In our example, if 300 units are exhausted at first payment in May 2020 and another 300 units are exhausted at the final repayment in July 2020, when the first 300 units are exhausted, 100 units are considered to be held for long term and 200 units for short term. And when the final repayment happens, the remaining 300 units are considered to be held for short term.

Cost of acquisition

As per the I-T Act, the cost of acquisition of the segregated portfolio would be a portion of your total cost of acquisition of original units. That said portion is calculated in the proportion that the NAV of the segregated portfolio bears to the NAV of the total portfolio immediately before the side-pocketing.

On the date of segregation, the NAV of segregated portfolio before segregation will be disclosed by the AMC.

For instance, pursuant to the downgrade of debt instruments of Vodafone Idea to ‘BB-’ by CARE Ratings Limited on February 17, 2020, UTI Mutual Fund created a segregated portfolio under many schemes. In its press release, the fund house disclosed that that NAV of segregated portfolio for UTI Credit Risk Fnd is 2.61 per cent of total net assets before segregation.

In our example, say the NAV of the segregated portfolio is 10 per cent of the total portfolio’s NAV before the date of segregation.

Therefore, your cost of acquisition for the segregated portfolio would be 10 per cent of your acquisition cost. That is ₹580 (10 per cent ₹5,800).

Note that, the cost of acquisition of the main portfolio will be total cost of acquisition minus cost of acquisition of segregated portfolio. Thus in the example, main portfolio’s acquisition cost would be Rs 5,220 (Rs 5800 – Rs 580).

Sometimes, a few AMCs, before segregating the mutual funds, write down the value of the instruments being segregated to zero. This might differ from fund house to fund house.

For instance, when Vodafone Idea bonds were downgraded, fund houses such as UTI, Nippon India and Franklin Templeton created a segregated portfolios for such instruments. But only Franklin written down the value of such investments to zero.

In that case when the value is written down to zero before segregation, the cost of acquisition of units in segregated portfolio would be nil and the whole proceeds received from AMC would be considered capital gains.