Prime Q&A: How are segregated mutual fund units taxed?

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Q: I received some money from the segregated mutual fund units of some Franklin debt funds as a result of interest payment by Vodafone. I am told that the entire amount is taxable? How is that? Is the taxation not on a proportionate basis for such units? How can the cost of my Franklin units be zero? Is it different for different AMCs?

A: Vodafone Idea made its annual coupon payments on its debt instrument. This paper was held by some of the debt funds as part of their segregated portfolios after the paper was downgraded in January 2020. The amount received was distributed as partial payment by the fund houses to investors. Franklin India also did the same with the segregated units of the six debt schemes it recently closed.

A mutual fund segregates that part of its portfolio that has gone bad and has become illiquid. This is created as a seprate portfolio and the rest remain as part of the main portfolio. As and when money is received back on the bad assets, the mutual fund should distribute the same.

Budget 2020 brought some clarification on how the amounts received by an investor in segregated mutual fund units (also called side-pocketed units) need to be taxed. For this purpose, let us understand the definition of a few terms:

  • Main portfolio – the portfolio with the good assets, which can still be bought or sold
  • Segregated portfolio – the portfolio with the stressed assets that cannot be bought or redeemed
  • Total portfolio – the sum of the above two, before they were segregated

When a portfolio is segregated you are allotted the same number of units as the main portfolio.

What you would need to know when you calculate capital gains for both the main and segregated portfolios are:

  • one, the holding period
  • two, the cost of acquisition

 Let’s see how these are to be determined.

Budget 2020, applicable from FY 2020-21, clarified that the holding period of the segregated portfolio will be from the original date of acquisition of the main portfolio. That means, the date of segregation does not count. What counts is when you bought the total portfolio, before segregation. For example, had you bought a fund in May 2019 and it underwent segregation in May 2020, your date of acquisition for the main portfolio as well as the segregated portfolio would only be May 2019.

Next is the cost of acquisition. Here, the Income Tax Act says that the proportion by which the split happened (on segregation) would apply for the cost of acquisition as well. Let us suppose a fund that you had bought at a NAV of Rs 10 grew to Rs 100 (at the time of segregation) and was segregated as Rs 90 (main portfolio) and Rs 10 (segregated portfolio). Then the cost of the segregated portfolio will be 10% of Rs 10 NAV cost – which is Re 1 – and the cost of main portfolio would be Rs 9.

Once the cost of acquisition is known, the taxation of capital gains – whether short term or long term would apply based on the asset class and time frame. You can read about capital gains tax for funds here.

Franklin’s segregated units

In the case of the segregated units of Franklin India debt funds, created for stressed assets in Vodafone idea, the cost of acquisition of the segregated units is indeed zero. This is because Franklin’s debt schemes had written off the Vodafone paper in full, before they segregated it. So, the cost of the segregated units was zero at the time of segregation. This essentially means that the entire receipt for these segregated units will be taxed as capital gain – long-term or short term.

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11 thoughts on “Prime Q&A: How are segregated mutual fund units taxed?”

  1. The answer to the question on taxation of segregation is clear but needs one more clarity.If long term capital gain is applicable for a segregated folio whose cost of acquisition is zero(Franklin Templeton),the indexation benefit is nil ,so in such case LTCG will be taxed at which rate 10% or 20%

  2. That was crisp and clear article. Thank you.
    “This essentially means that the entire receipt for these segregated units will be taxed as capital gain – long-term or short term.”
    Essentially means that we pay more tax but there is no complexity of calculations. Just take the amount received from FT and pay tax on it. 🙁

    1. True. However, remember that in the original units the full cost will be there. SO when you sell, you will be able to claim capital loss or at least lower tax. thanks, Vidya

    2. shrikant khadilkar

      I think the the article is saying differently, isn’t it. Entire receipt will not be the capital gain. Rather the cost of of acquisition needs to be know and then the capital gains will need to be calculated.

      1. Hello Sir, yes, Just that the cost of acquisition in the case of Franklin Vodafone segregated units iz zero (since the fund first wrote it off to zero and then was directed by SEBI to segregate it). So there is no contradiction. thanks, Vidya

  3. Hi

    Can you please let us know what are Put & Call option as mentioned in Maturity profile of FRANKLIN Schemes and also Interest rate resets ? I would like to know will these options put any pressure on borrowers in current scenario in honoring these towards repayments well before their due dates and the criteria for selecting only few bonds in the entire list . Request you to shed some light on these in simpler times .

    Thanks
    Arun

  4. Hi All, hope you are doing well. Am glad to say that I had experienced your leadership as am employee and will always be thankful for that.
    The above detailing about the taxation is extreme perfect. Most of the investors needed the clarity on COA and is well explained.
    Thank You.

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