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Market Linked Debentures – Taxation, Benefits, and Risks

by | Apr 30, 2024 | Income Tax | 0 comments

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Important Keyword: Income from Capital Gains, Income Tax, Market Linked Debentures.

Market Linked Debentures – Taxation, Benefits, and Risks

Market Linked Debentures (MLD) are a type of non-convertible debentures where the returns are not fixed but rather tied to the performance of the market. Unlike regular coupon-bearing debentures, MLDs don’t offer a fixed payoff. Instead, their returns depend on the movement of another security or index, such as the NSE Nifty index or the 10-year government security (G-sec) yield. For instance, if an MLD has a tenure of 30 months, it would pay the investor a predefined Internal Rate of Return (IRR) at the end of the term if the Nifty 50 Index does not fall by more than 75%.

Market-Linked Investments offer investors the potential for either full or partial market downside protection, along with the opportunity for enhanced returns. The tax treatment of market-linked debentures is similar to the taxation applied to bonds and debentures.

Why Market Linked Debentures (MLD)?

Market-linked debentures offer investors a unique opportunity to participate in the upside potential of various markets, such as equity (NSE Nifty) or G-sec, without bearing the full risk associated with direct investment in these assets. Unlike traditional debentures, market-linked debentures do not pay any coupon before maturity. Instead, upon maturity, investors receive a return, providing them exposure to potential market gains.

Investing directly in assets like the Nifty or gold carries the risk of losing a portion of the principal if the value of these assets declines over the investment period. Market-linked debentures mitigate this risk by offering a structured pay-off, allowing investors to benefit from market movements without exposing themselves to undue risk.

Taxation of Listed Market Linked Debentures

According to the Income Tax Act, market-linked debentures are classified as securities, with a period of holding for listed securities set at 12 months. Here’s how listed market-linked debentures are taxed:

Capital GainPeriod of HoldingTax Rate
Long Term Capital GainHolding Period > 12 months10% without Indexation under Section 112
Short Term Capital GainHolding Period <= 12 monthsSlab Rates
Taxation of Unlisted Market Linked Debentures

Unlisted market-linked debentures, like their listed counterparts, are considered securities under the Income Tax Act. However, the period of holding for unlisted securities is extended to 36 months. Here’s a breakdown of the tax treatment for unlisted market-linked debentures:

Capital GainPeriod of HoldingTax Rate
Long Term Capital GainHolding Period > 36 months20% without Indexation under Section 112
Short Term Capital GainHolding Period <= 36 monthsSlab Rates

If you’ve earned income from the sale of market-linked debentures (MLDs), it’s essential to report it as capital gains in the Income Tax Return (ITR-2) filed on the income tax website.

Benefits of MLDs

The taxation of MLDs offers efficiency in investment returns. Listed MLDs are subject to a 10% tax rate if held for over a year, while those held for up to a year are taxed at slab rates. Unlisted MLDs, on the other hand, are taxed at 20% if held for more than 36 months and at slab rates if held for up to 36 months.

Investors benefit from this structure in several ways:
  1. Principal Protection: Unlike pure equity investments, where capital loss is a risk, MLDs offer protection of the principal amount invested.
  2. Superior Return Potential: MLDs provide the potential for higher returns compared to traditional fixed-income investments when certain equity conditions are met.
  3. Balanced Structure: MLDs strike a balance between two conventional asset classes, offering investors a diversified investment option.

In addition to simple structures like the one described above, there are various other complex MLD structures, including:

  • Principal-protected structures with a participation rate linked to an underlying index.
  • Structures offering payoffs in the event of equity market declines.
  • Structures with less than 100% principal protection.

These diverse structures cater to different investor preferences and risk appetites, providing flexibility and customization in investment choices.

Risks associated with Market Linked Debentures

Understanding the issuer’s profile is crucial when considering investments in market-linked debentures (MLDs), especially since many structures offer principal protection. If the issuer fails to fulfill their obligations, investors may incur capital losses.

Conducting thorough due diligence on the issuer’s underlying business, diversification, and key financial ratios is essential before making any investment decisions.

Additionally, the payment of coupons is contingent upon specific market-linked conditions. Investors must assess the likelihood of these conditions being met before investing.

Due to the complexity of MLD structures and the higher minimum allocation required, these investments are best suited for High-Net-Worth Individuals (HNIs) and Ultra High Net Worth Individuals (UHNIs) who have a deep understanding of the intricacies involved.

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Official Income Tax Return filing website: https://incometaxindia.gov.in/


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