Shorn of tax benefit, MLDs now face tax deduction on payouts

Dayita Kanodia | Executive

finserv@vinodkothari.com

Background

The Finance Bill, 2023^[1], has quite nearly caused the demise of the so-called “Market-Linked Debentures” (MLDs)^[2]. The changes made pursuant to the Finance Bill, 2023, took away what seemed to be a strong reason for popularity of MLDs, i.e., the tax arbitrage.

Prior to the change, listed MLDs had the advantage of being exempt from the withholding tax under section 193 of the Income Tax Act, 1961, as well as being taxed at 10% as Long Term Capital Gains (LTCG) tax, if held for at least 12 months.

Finance Bill, 2023 inserts a new section 50AA to the Income Tax Act, 1961, which makes MLDs to be taxed at slab rates as a short term capital asset in all cases at the time of  transfer or redemption on maturity, irrespective of the period of holding, therefore losing out on the earlier lower LTCG rate of 10%.

In addition, the earlier exemption from withholding tax on listed debentures has now been removed pursuant to an amendment in section 193, which means that interest paid on listed debentures would now be subject to withholding tax with effect from April 01, 2023^[3].

MLDs are different from plain vanilla bonds in the sense that typically there is a premium paid on redemption, giving rise to capital gains in the hands of the investor. Further, this premium was linked with some external parameter, representing a market rate or external benchmark  – hence the name “market linked debentures”. Further, most MLDs are listed. This double whammy of changes brought about by the Finance Act, 2023, coupled with the nature of MLDs, gives rise to a perplexing question – “Will TDS (Tax Deduction at Source) be applicable on the servicing of MLDs done on or after 1st April, 2023?” There may be further intriguing questions:

• Is the TDS applicable based on the date of payment, or the period of accrual? For example, if the interest or servicing relates to a period partly before 1st April, 2023, and partly on or after that, what is the applicability of TDS?
• Is the deduction of tax to be done at the time of accrual of the premium or return on the MLDs, or at the time of payment of the premium on redemption?
• Does the insertion of sec. 50AA, which treats the redemption premium on MLDs as capital gains, make a difference when it comes to TDS in the hands of the issuer? If the income in the hands of the recipient is short term capital gain by statutory presumption, can the issuer still deduct tax at source on “interest”, resulting in a difference between the TDS as shown by statement in 26AS, and the income returned by the investor?
• Does it make  a difference if the MLDs have changed hands prior to their redemption, such that the erstwhile owner would have exited at a transfer price and paying capital gains tax, whereas the incoming investor would have acquired at a price, and will only get the differential premium, if any?

These questions were not faced by MLD issuers in the past, as the MLDs, being listed instruments, enjoyed exemption from withholding tax. However, now that the exemption is gone, all these questions haunt practitioners.

Through this article the author attempts to address these intriguing questions.

Tax deduction at source on MLDs – the when, why and how?

The concept of TDS was initially introduced with the intent to have tax collected at the very source of the income being received by the assessee. The person who is liable to make a payment is responsible to deduct tax on such payment at source.

The deduction of tax at source should ideally be based on the nature of income of the recipient, and not on the basis of the nature of expense of the company. It is deduction of tax at source, where the tax was otherwise payable by the recipient and the company/ issuer is simply deducting the same at source.

Section 193 of the Income Tax Act, 1961 is the relevant section that deals with TDS on interest on securities (for non-residents the relevant section is section 195, discussed later). The section states that “The person responsible for paying to a resident any income by way of interest on securities shall, at the time of credit of such income to the account of the payee or at the time of payment thereof in cash or by issue of a cheque or draft or by any other mode, whichever is earlier, deduct income-tax at the rates in force on the amount of the interest payable”.

Accordingly, the issuer is required to deduct tax at source on any “income by way of interest” to be paid on securities at the time of payment or at the time of credit of such “income” to the account of the payee. The section refers to “income” and not “expense”, therefore, to determine the applicability of section, we must first understand the nature of “income” that the investor earns on the MLD.

Payouts on MLDs – in the nature of interest or premium?

Most MLDs do not pay interest every year but rather give a lump sum amount at the end of the tenure.

Further, as mentioned above, section 193 requires any person responsible to pay interest on securities to a resident, to deduct taxes at the applicable rates at the time of payment or at time of crediting such income in the payee account. The section refers to “income” and not “expense”, therefore, to determine the applicability of section we must consider the colour of the “premium” or “yield” on the securities from the perspective of the investor and not the issuer.

In the current scenario, even though the issuer is likely to recognise the amount as an expense in the nature of debt service, in the hands of the investor, the premium received will be in the form of “capital gains”. Accordingly, if by a clear provision of law, the nature of income in the hands of the recipient is that of capital gains, the question of any deduction at source u/s 193 does not arise. Our view, in case of MLDs, gathers further force as a non-obstante provision has been inserted by FA 2023 clearly providing for  taxation on gain on the bonds as short term capital gain.

However, it is a common practice among companies to transfer debt service at regular intervals. The question becomes even more complicated in case of IndAS-following entities, because even instruments like redeemable preference shares may be treated as debt under IndAS, and the difference between the initial fair value and the redemption value of these instruments may be treated as the cost of debt under IndAS. There may be liabilities not having any interest at all – for example, a security deposit. The interest-free security deposit is fair valued at inception, and then, the discount on fair valuation is unwound over a period of time, as cost of debt. The point we are trying to establish is:

• The fact that an instrument is treated as debt for accounting purposes does not mean it is debt for legal or tax purposes.
• The fact that there is a cost of debt in books of account does not mean such cost is “income by way of interest” in the books of the recipient.

Once again, we reiterate that the intent of tax deduction at source is that the recipient is receiving an income, which is taxed at source.

Drawing parallels with deep discount bonds

While the Finance Act is silent on the question of deduction of tax at source, we may get some assistance by referring to the circulars issued in the context of deep discount bonds.  Deep Discount Bonds are similar to MLDs as they are issued at a discount at the inception, and give out a fixed payment at the time of maturity. Notably, discount on issue, or premium on redemption, amount to the same thing, and hence, a deep discount bond is conceptually the same as a zero coupon bond. We are refraining from using the term “zero coupon bond” as there is a specific definition of that term under section 2(48) of  the Income Tax Act.

A 2002 circular on deep discount bonds states that – “Where the bond is transferred at any time before the maturity date, the difference between the sale price and the cost of the bond will be taxable as capital gains in the hands of an investor or as business income in the hands of a trader.”

On the other hand, when the bond is redeemed by the original subscriber, the difference between the redemption price and the value as on the last valuation date immediately preceding the maturity date will be taxed as interest income in the case of investors, or business income in the case of traders.

However, as mentioned above, businesses have a common practice of transferring the cost of debt every year. However, the investors wouldn’t have accrued interest. This leads to an asymmetry between the tax deducted at source, and the income reported by the taxpayer.  As per income-tax rules, if the tax deducted does not match with the income reported, then the taxpayer will not get the credit for the same. Therefore, a second circular was issued by the income tax authorities in the year 2004  clarifying that tax is required to be deducted at source under section 193 or section 195, as the case may be, only at the time of redemption of such bonds, irrespective of whether the income from the bonds has been declared by the bond-holder on accrual basis from year to year or is declared only in the year of redemption. However a person, who has declared the income from a Deep Discount Bond on annual accrual basis during the term of the bond, will be entitled to make an application under section 197 of the Income-tax Act, requesting the Assessing Officer to issue a certificate for no deduction of tax or deduction at a lower rate

Would this apply to MLDs?

By its nature, Market Linked Debentures usually offer positive returns at the time of redemption, based on the performance of an underlying asset/ index or condition, while guaranteeing principal/ investment amount back, even if there is a downside in the performance of the underlying asset/index such as NIFTY, equity, bonds, fixed-income securities etc.

Again, for deep discount bonds the redemption price is normally the face value of the bond, and the issue price is the discounted value and it is because of this that they are called ”deep discount bonds”. Therefore, both Market Linked Debentures and Deep Discount bonds offer returns only at maturity and as such no regular interest is paid. The one difference being that in case of deep discount bonds, the amount payable on maturity is determinable initially, however, the same is not the case for MLDs since the amount payable at maturity is performance linked.

However, the Income tax act is silent on the tax treatment for MLDs, we can draw parallels with the deep discount bonds, given that there exists similarities in their nature. In both cases, there is an amount payable at redemption and there is normally no interest paid during the life of the bond. Accordingly, we may say that by drawing parallels, the intent of the aforementioned circulars should also apply in case of MLDs.

Tax disparity for Non-Residents

The tax treatment for non-residents is a bit different. They are covered under Section 195 of the finance act which states that- Any person responsible for paying to a non-resident, not being a company, or to a foreign company, any interest or any other sum chargeable under the provisions of this Act shall, at the time of credit of such income to the account of the payee or at the time of payment thereof in cash or by the issue of a cheque or draft or by any other mode, whichever is earlier, deduct income-tax thereon at the rates in force. Further, explanation to section 195 states that where any interest or other sum as aforesaid is credited to any account, whether called “Interest payable account” or “Suspense account” or by any other name, in the books of account of the person liable to pay such income, such crediting shall be deemed to be credit of such income to the account of the payee and the provisions of this section shall apply accordingly. Therefore, section 195 unlike section 193 is not restricted to just interest income and will nevertheless apply.

Answering the question

So, now coming back to the question we started with- to deduct or not to deduct tds on MLDs? As stated earlier, the deduction of tax at source should ideally be based on the nature of income of the recipient, and not on the basis of the nature of expense of the company. Therefore, the nature of income being that of capital gains for the investor, the gain should ideally be charged to short term capital gain for the investor.

However, if the issuer was to claim expenses against the MLDs over the tenure of the instrument, it would have to first appropriate the expense for the year, and also deduct TDS. Deduction of TDS for claiming interest expenses is a prerequisite, as mentioned in the proviso to section 40(a)(i)^[4]. There seems to be a gap in the way the amount is accounted for in the books of the investor and the issuer, and that is the source of all the ambiguities in the present case. In case, the issuer decides to defer the recognition of expense till the maturity, this problem will not arise.

If tax was deductible, but was not deducted, then in that case most certainly, the expense would be disallowed. However, if tax was not deductible at all, by the very nature of the expense, then there is no question of deduction of tax at source in the first place.

If a company is paying any coupon on the MLDs, whether over time or on maturity, the same will be liable to TDS u/s 193 or 195 respectively, however, where the Company is paying a premium on redemption, and that too, is based on underlying market relatable factors, it cannot be contended that the premium is in the nature of interest. Taking such a view will go against the non obstante provision of sec. 50AA.

To answer the question, since deduction of tax at source is based on the nature of income of the recipient and the nature of income for the recipient in case of MLDs is capital gains and not interest, there is no question of tax deduction at source under section 193 of the Income Tax Act, 1961 in case of residents.

Section 195 on the other hand requires the payer to deduct tax on payment to any “non resident” on any “interest” or “other sums” taxable under this Act. Further, the explanation 1 says that where any interest or any other sum is credited to any account, whether called “interest payable account” or “suspense account” – even if not paid, shall be deemed to have been credited to the account of the payee, and accordingly TDS must be deducted. The scope of this section goes beyond “interest”, therefore, this section shall still apply in our view, as discussed above.

Withdrawal of 193 exemption- how will it affect other securities?

The withdrawal of the earlier exemption provided for listed debentures affect other securities (other than MLDs for reasons mentioned above) and has left entities with a lingering question – “do we deduct tax for the whole year if the interest falls due after April say, on the 10th of april 2023.” 

The answer is – “NO” since TDS deduction should be proportionate to the time period of applicability of the said provision. Hence, only that part of the interest which pertains to the period between 1st april and 10th April 2023 should be liable to TDS.

Read our other articles on similar topics –

Melt-down of Market-linked debentures, Debt mutual funds get fatal blow

Market-linked debentures: Is it the end of the market for them?

Market-Linked Debentures – Real or Illusory?

 

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^[1] https://www.indiabudget.gov.in/doc/Finance_Bill.pdf

^[2]For a deeper understanding of MLDs in India, read our article here – https://vinodkothari.com/2021/01/market-linked-debentures-real-or-illusory/

^[3] Read our article on the proposed amendments and their implications to MLDs – https://vinodkothari.com/2023/02/marked-linked-debentures-is-it-the-end-of-the-market-for-them/

^[4] https://incometaxindia.gov.in/pages/acts/income-tax-act.aspx