Budget 2020 through Finance Bill 2020 has amended the income tax provisions related to segregated portfolios of mutual funds and provides clarity as to the taxation of Segregated portfolios of Mutual Funds and how the cost of acquisition is considered in case mutual funds are segregated and what is the holding period of segregated portfolios of mutual funds units. Earlier, SEBI in 2018 has allowed mutual funds to segregate the portfolios for downgraded debts from the main portfolio.
It was a long-standing demand of the mutual fund industry to provide clarity on the taxation of segregated portfolios of mutual fund units. Segregation of portfolios is also known as “side pocketing".
The concept of a Segregated Portfolio is promulgated by the Securities and Exchange Board of India (SEBI) in December 2018 by a circular and is a procedure that allows mutual funds to separate a certain number of units against downgraded debts and money market instruments held by them.
The concept of a Segregated Portfolio is promulgated by the Securities and Exchange Board of India (SEBI) in December 2018 by a circular and is a procedure that allows mutual funds to separate a certain number of units against downgraded debts and money market instruments held by them.
Create of a segregated portfolio or side-pocketing was
introduced by SEBI to enable debt schemes of a mutual fund to allow investors
to exit a debt scheme in distress. It is implemented by debt funds if their
holdings are downgraded below investment grade or suffer from a default.
Side-pocketing facilitates the separation of units into a
distinct portfolio, in which no fresh subscriptions are allowed. Investors can redeem these units
once the money is recovered from the bad debt, while they can redeem other units at
any point of time.
Recently, on 18th February 2020, the UTI mutual
Fund has announced to create a segregated portfolio for its five of the schemes
namely, UTI Credit Risk Fund, UTI Bond Fund, UTI Regular Savings Fund, UTI
Dynamic Bond Fund and UTI Medium Term Fund due to the fact that Care Rating has
downgraded the debt instruments of Vodafone Idea to ‘BB-’ (i.e. below investment
grade) on February 17 and UTI mutual fund schemes have exposure of Rs 180 crore
in debt instruments issued by Vodafone Idea.
In the context of a 'segregated portfolio', it is important to know the following three concepts-
1. The term ‘segregated portfolio’ shall mean a portfolio, comprising of debt or money market instrument affected by a credit event, that has been segregated in a mutual fund scheme.
2. The term ‘main portfolio’ shall mean the scheme portfolio excluding the segregated portfolio.
3. The term ‘total portfolio’ shall mean the scheme portfolio including the securities affected by the credit event.
The total portfolio is the portfolio which is the original one and then is splitted into two portfolios-main portfolios and segregated portfolios.
The main portfolio is the portfolio which is separated from the 'total portfolio' with good debts and can be redeemed by the investor at any point of time.
The segregated portfolio is that part of the total portfolio which contains the bad, downgraded and illiquid debts.
Creation of a segregated portfolio (also known as “side-pocketing”) is a mechanism wherein the mutual fund isolates or segregates the stressed, illiquid asset from the rest of the holdings in the scheme’s portfolio and the unitholders in the scheme are allotted units of the side-pocket, in the same ratio as the investment in the parent scheme.
Units of the side-pocket are not redeemable, while the units in the main/original scheme portfolio are redeemable as usual.
Thus, instead of redemption being suspended in the entire scheme, only the side pocketed portion is frozen until the market conditions improve, and the stressed asset could be sold at a price that better reflects its intrinsic value. This prevents the stressed assets from adversely impacting the returns generated by the rest of the holdings in the scheme’s portfolio. The segregated portfolio shall have different net assets value (NAV).
In the backdrop of the aforesaid circumstances, the Budget 2020 has amended the Income Tax Act, 1961 to provide clarity with regard to the capital gains tax treatment upon the sale of Units in the
(a) Main Portfolio (with healthy portfolio); and
(b) the segregated portfolio (containing stressed assets)
in the hands of the unitholder.
The Finance Bill, 2020 has proposed the following amendments related to segregated portfolios of a mutual fund scheme-
(a) the holding period with respect to the segregated units shall be reckoned from the original date of acquisition of units in the Main portfolio; and
(b) the cost of acquisition of Units in the Main Portfolio and the Segregated portfolio will be taken as the proportionate cost as determined on the date of segregation for the Main Portfolio and for the Segregated portfolio.
The period of holding of such units shall be reckoned from the date of investment by the investor under section 2(42A). The period of holding of segregated units will include the total period of holding in the Main portfolio i.e., from the date of investment by the investor.
The cost of the acquisition of the original units held by the unit holder in the main portfolio shall be reduced by the amount as so arrived for the units of segregated portfolio.
The cost of acquisition in the case of the Main portfolio and the Segregated portfolio shall be the proportionate cost as determined on the date of segregation for the purposes of section 49. The cost of acquisition of Units of the Main portfolio and the segregated portfolio should be the proportionate cost thereof as determined on the date of segregation, since the aforesaid SEBI circular dated December 28, 2018, clearly mandates that all existing unitholders in the affected scheme as on the day of the credit event shall be allotted equal number of units in the segregated portfolio as held in the main portfolio.
These amendments are applicable from AY 2020-21.
Clause(42A) of section 2 defines the expression “short term capital asset” to be a capital asset held by an assessee for not more than thirty-six months immediately preceding the date of its transfer.
If the unit or units in a segregated portfolio are held for 36 months from the original date of acquisition of units in the Main portfolio then the same will constitute 'short term capital assets' and any capital gains arising therefrom shall be considered as 'short term capital gain'.
On the contrary, if the unit or units in a segregated portfolio are held for more than 36 months from the original date of acquisition of units in the Main portfolio then the same will constitute 'longterm capital assets' and any capital gains arising therefrom shall be considered as 'longterm capital gain'.
Although suitable amendments have been made with regard to the treatment of the units allotted consequent on segregation of portfolio of a mutual fund scheme in the hands of the unitholder for the capital gains tax purposes in relation to determining the cost of acquisition and the period of holding but it appears that the lawmakers forget to amend section 47 to exclude creation of a segregated portfolio from the definition of 'transfer'.
The allotment of units in a segregated portfolio of a mutual fund scheme shall not be considered as 'Transfer' under section 47 of the Income Tax Act, 1961. When the consolidation of mutual fund schemes as per SEBI guidelines are not regarded as transfer then why not the de-consolidation or segregation of schemes shall not be regarded as not a transfer for the purpose of capital gains taxation. Further, it should be noted that switching of mutual find schemes is regarded as a transfer.
For an assessee, capital gains tax liability on investment in mutual fund units arises only on redemption or transfer of the units. In the case of side-pocketing, the number of units remains unchanged — only the NAV of the units of the Main portfolio reduces to the extent of the portfolio segregated from the main portfolio. Therefore, there is no Transfer or Redemption of the units held by the investor.
Hence to clarify the issue, it would be better if an explicit provision is included in section 47 for the segregated portfolios.
Segregation of portfolio or side-pocketing is actually to be seen as splitting the investments into two parts, one is called the 'main portfolio' and another part is called the 'segregated portfolio'.
The creation of the segregated portfolio is driven by the trustees to protect the interest of the investors, under certain adverse circumstances of rating downgrade or credit default and in accordance with SEBI guidelines.
Let us understand the amendments with respect to the Taxation of Segregated Portfolios of Mutual Fund Units in simpler terms.
It is now clarified the holding period and cost of acquisition with regard to units allotted consequent on segregation of portfolio of a mutual fund scheme due to rating downgrade and credit default, known as 'credit event'.
Accordingly, the holding period of the segregated scheme will be reckoned from the date of investment in the main portfolio by the investor and not the date of segregation.
The cost of acquisition of the main scheme and segregated scheme will be the proportionate cost as determined on the date of segregation.
In the absence of any amendment in section 47, it appears that 'transfer' will take place at the time of segregation of the portfolio, though it does not appear to be the intention. Hence, a suitable amendment in section 47 is warranted.
Suppose Mr. Rakesh invested in a scheme of a mutual fund on 01-01-2015 when the NAV was Rs. 10. On May 1, 2019, when NAV of the scheme was Rs. 20, segregation of portfolio was created due to a credit event.
Post creation of the segregated portfolio, the NAV of the main portfolio was Rs. 16 and the segregated portfolio was Rs 4. Hence, the proportion is 80:20 of the total portfolio. According to the proposed amendment, the cost of acquisition of the main portfolio and the segregated portfolio should be taken as Rs. 8 and Rs. 2 respectively.
Similarly, the period of holding the units of the main portfolio and the segregated portfolio should be reckoned from 1st January 2015.
Read the SEBI circulars:
Creation of segregated portfolio in mutual fund schemes dated December 28, 2018 (referred to in section 49 of the Income Tax Act, 1961)
Creation of segregated portfolio in mutual fund schemes dated November 07, 2019 (with partial modifications for unrated debt instruments)
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