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Budget 2019 needs to introduce provisions to deal with splitting of MF portfolio

Suraj Nangia
Budget 2019, Budget proposal, Budget 2019 india, NAV, mutual funds, corporate bond, tax, Net Asset Value,

Budget 2019 India: Given the large-scale defaults in the corporate bond space and a large number of mutual funds having exposure to bad debt paper, it is likely that fund houses will go for splitting of the portfolio. It is crucial that clarity is provided in the Budget on tax treatment for funds and investors affected by such a split. The Securities and Exchange Board of India (Sebi) allows a mutual fund to segregate the downgraded or bad debt securities from the investment grade securities into a separate scheme with a separate Net Asset Value (NAV).

Investors are allotted new units for the new portfolio and as a result the NAV of original units is revised. No transactions are allowed in the units of new portfolio till recoveries are made from defaulting companies.

Sale of units
On sale of either category of units there can be gain or loss for the investor. For this purpose one needs to determine the cost of purchase of original and new units for tax purposes. Broadly, there can be two methods one where no cost is attributed to new units and the other where cost is attributed on some basis.

Budget 2019, Budget proposal, Budget 2019 india, NAV, mutual funds, corporate bond, tax, Net Asset Value,

There are certain provisions in the law that cover situations like issue of bonus shares whereby when a shareholder who is allotted bonus shares without any cost, on sale of bonus shares the cost is taken as nil and the period of holding of bonus shares is calculated from the date of allotment of bonus shares. Applying that provision, one would calculate tax by deducting entire cost from sale/redemption proceeds of original units, and nothing from redemption proceeds of new units. If, however, an investor happens to sell new units first (post recovery) and it happens to be a short term gain which attracts higher tax, one would want to deduct some proportionate cost from such gains. Further, commercially the investor may be making loss on the transaction because the recovery of bad debt may be lower than 100% or even the written down NAV and hence taxing such an investor on entire proceeds and that too at short term capital gain rates would be grossly unfair.

Fair allocation of cost
This kind of a situation should be compared with that of a corporate demerger. In a corporate demerger the original cost of shares is allocated over original and new shares, based on net worth of the businesses which are split. In the mutual fund industry, perhaps the NAV is closest to the concept of net worth of a company s business units and hence a fair allocation of cost could be on the basis of two NAVs, the NAV of original units post-split and the NAV of new units. In the absence of any other logical or rational basis like the face value, NAV appears to be most logical and fair basis of allocating original cost.

Let us assume that an investor makes an investment of Rs 1,00,000 on 10,000 units asnd the current value/NAV is Rs 1,50,000 at Rs 15 per unit. If such a portfolio had a bad portfolio of pre-write-down value of Rs 30,000, on segregation of bad portfolio, the revised NAV of good portfolio would be Rs 12 (1,20,000 / 10,000). If the bad portfolio is written down by 50%, the new units would have a NAV of Rs 1.5 (50% of 30,000 / 10,000).

Assuming a sale/redemption price of Rs 14 for original and Rs 2 for new units, the gains would be as shown in the graphic: (What you gain). It can make a substantial difference depending on how calculations are made. Given that the number of mutual funds with exposure to bad debt paper and the investors affected are huge, we are likely to see more instances of such splits the new Budget proposals must introduce provisions to deal with the such splitting of portfolio. Further, it should be provided that where no recovery is made at all from the bad portfolio, the write-off should be allowed as a loss despite there being no transfer of such units.

The writer is partner with Nangia & Co. The views expressed here are personal.