Market Linked Debentures – Taxation, Benefits, and Risks

Market Linked Debentures i.e. MLD are non-convertible debentures where the returns are not fixed but linked to the market. The return on MLD depends upon the performance of the underlying index. Thus, in case of MLD, there is no fix pay-off like in case of a regular coupon-bearing debenture. The return depends upon the movement in another security or index such as NSE Nifty index or 10-year government security (G-sec) yield. For example, a 30-month MLD would pay the investor a pre-defined IRR at the end of the tenure if Nifty 50 Index does not fall by more than 75%. Market-Linked Investments may provide full or partial market downside protection and/or enhanced return potential. The tax treatment of market linked debentures is same as income tax on bonds and debentures.

Why Market Linked Debentures (MLD)?

A market-linked debenture does not pay any coupon before maturity. On maturity, apart from the initial principal component, there is a pay-off, i.e., a return payable. The advantage is that you are getting the exposure and upside in other markets such as equity (NSE Nifty) or G-sec, without taking as much of a risk as in investing directly into that asset.
If you invest directly in the Nifty or gold and Nifty or gold value declines over the investment horizon, you would lose a part of the principal.

Market Linked Debentures Taxation

Income Tax on Listed MLD

Market Linked Debenture is security as per the Income Tax Act. The period of holding in the case of listed securities is 12 months. Below is the tax treatment of listed market linked debenture:

Capital Gain Period of Holding Tax Rate
Long Term Capital Gain Holding Period > 12 months 10% without Indexation under Section 112
Short Term Capital Gain Holding Period <= 12 months Slab Rates

Income Tax on Unlisted MLD

Market Linked Debenture is security as per the Income Tax Act. The period of holding in the case of unlisted securities is 36 months. Below is the tax treatment of unlisted market linked debenture:

Capital Gain Period of Holding Tax Rate
Long Term Capital Gain Holding Period > 36 months 20% without Indexation under Section 112
Short Term Capital Gain Holding Period <= 36 months Slab Rates

The taxpayer having income from sale of MLD must report it as income from capital gains in the ITR-2 that he/she files on the income tax website.

Benefits of Market Linked Debentures

  • Taxation of this instrument is efficient. The listed market linked debentures are taxable at 10% if held for more than a year and at slab rates if held for up to 1 year. The unlisted market linked debentures are taxable at 20% if held for more than 36 months and at slab rates if held for up to 36 months.
  • The benefit that investors have in a structure like this is:
    • Principal protection as compared to a pure equity investment where there is risk of capital loss.
    • Superior return potential vs traditional fixed income on fulfillment of an underlying equity condition
    • Structure which is at a candy spot versus two traditional asset classes.
  • While the above example would be that of a simple structure, there are various other complex structures like:
    • Principal protected with a participation rate linked to an underlying index,
    • Principal protected structures which gives a pay off if equity markets go down,
    • Less than 100% principal protection structures etc.

Risks associated with Market Linked Debentures

  • Issuer’s Profile
    • Although a majority of structures are principal protected, the ability of the issuer to repay is of huge importance.
    • Investors may suffer a capital loss in case the issuer fails to repay on the obligation.
    • Thorough due diligence on the issuer’s underlying business, its diversification, and key financial ratios should be undertaken before investing.
  • Fulfillment of the underlying market linked condition
    • Secondly, payment of coupon depends upon a certain market linked condition.
    • Investors need to determine a probability on the fulfillment of the underlying market condition.
  • Due to the complexity of structures and higher minimum allocation, these structures are suitable for HNI and UNHI clients who understand the nuances correctly

FAQ

Are market-linked investments good?

Market-Linked Investments provide access to a wide variety of asset classes, including some not readily available to an individual investor. Further, these investements may provide full or partial market downside protection and/or enhanced return potential.

What is non convertible debentures?

Non-convertible debentures (NCD) are fixed-income instruments. They are usually issued by high-rated companies in the form of a public issue to accumulate long-term capital appreciation. They offer higher interest rates compared to convertible debentures.

How do we account for market linked debentures in books?

A market linked debenture is a loan taken by the company from the market with no provision of any fixed rate of interest. However, the return to the investors is dependent on some market index like Nifty or Sensex.

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