The Association of Mutual Funds of India (Amfi) has released a series of recommendations for Budget 2019. Among other suggestions, the list features a request for clarity on the taxation of side pocketed units (formally known as “segregated portfolios"). Side pocketing is a procedure promulgated by the Securities and Exchange Board of India (Sebi) in December 2018, which allows mutual funds to set aside a certain number of units against bad debt held by them. This is done in times of financial distress. A lack of clarity on the taxation of side pocketing can add to the problems of investors who have already suffered from a debt downgrade or default.
According to Amfi, the Income Tax Act, 1961 fails to adequately specify that the creation of separate side pocketed units does not constitute a taxable transfer within Section 47 of the I-T Act. It treats the date of acquisition for side pocketed units as the date on which side pocketing is done, rather than the original date of investment. It also takes the cost of acquisition as the original cost of acquisition rather than the proportionate cost on the date of side pocketing.
The first of these measures “resets the clock" for an investor in terms of capital gains. In debt funds, the capital gains tax rate falls to 20% if the investment is held for more than 36 months and the benefit of indexation is given. However, investments sold before then are taxed at the slab rate, which could be as high as 30%. For instance, let’s assume a mutual fund is purchased on 1 January 2017, and the scheme, facing bad debt, implements side pocketing on 1 January 2019. There is recovery in debt and the investor is able to redeem the side pocketed units on 1 January 2021. He will not get the benefit of long-term capital gains tax since the date of acquisition has been “reset" to 1 January 2019, even though he has held the investment for four years.
Another issue with the tax rules is that they do not correctly value the gains made by investors in these units. They consider the investor’s cost of acquisition to be the original cost rather than the proportionate cost on the date of creation of the side pocket. “Without explicit provisions, side-pocketed units will be considered extra or bonus units with nil cost of acquisition. This will artificially increase the tax on the gains made by the investor," said Gautam Nayak, a chartered accountant.
Side-pocketing was introduced by Sebi to enable debt funds to allow investors to exit a debt scheme in distress. It can be implemented by debt funds if their holdings are downgraded below investment grade or suffer from a default. Side-pocketing facilitates the separation of units, in lieu of bad debt, into a distinct portfolio, in which no fresh inflows are allowed. Investors can redeem these units once money is recovered from the debt in question, while they can redeem other units at any point of time. The segregated portfolio has a separate net asset value (NAV). Side pocketing allows an investor to exit a debt fund hit by defaults or downgrades without necessarily realising a loss. It also prevents new investors from taking advantage of a debt fund which has taken a large hit to its NAV, if there is recovery in the troubled debt.
The past two years have seen widespread falls in the NAV of debt funds as defaults emerged in corporate groups like IL&FS and DHFL. Most of the affected funds failed to utilize the provision of side-pocketing and instead resorted to measures like implementing exit loads or stopping fresh inflows.
However, a few asset management companies, like DHFL Pramerica Asset Managers Pvt. Ltd and Tata Asset Management Company, introduced side-pocketing into the scheme information documents of some of their funds. The latter implemented side-pocketing in Tata Corporate Bond Fund, Tata Treasury Advantage Fund and Tata Medium Term Fund. “The tax ambiguity on investors who have side-pocketed units should be removed, particularly because investors in such schemes have already suffered. The tax problem compounds their misery," said Vijai Mantri, chief investment strategist and Co-promoter, JRL Money, an investment solutions company.
Side-pocketing is aimed at insulating investors’ money in a debt crisis, but if it comes with tax implications, it can be counterproductive.
Although it has been used sparingly, with debt issues, the use of side-pocketing is likely to become more widespread. If there is any ambiguity about the taxation of side pockets, fund houses may be even more resistant to adopting the procedure. A clarification in Budget 2019 will go a long way in solving this problem.