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

  1. Sushil K Sawhney

    I have got the latest Capital Gains statement from Franklin Templeton as on 31 Jul 21 for FY 20-21. In the case of segregated debt fund Short Term Income Plan it states the NAV as zero, thereby implying that the cost of acquisition is zero. However in the same statement the main original NAV of the same plan has been reduced marginally. This would result in a double whammy to the extent that on the segregated side one has to pay tax on the full amount without any benefit of indexation and further pay higher tax on the main original STIP as the NAV of acquisition is reduced thereby increasing the gain. This somehow is unfair to my mind. Request clarify if this is in order.
    Can you madam clarify another issue which has resulted in my case due to this forced redemptions by Franklin Templeton on the debt funds. My total income FY 20-21 is Rs 2.4 Lakhs including the short term capital gains from Franklin Templeton. The LTCG is Rs 12.59 Lakhs. Is there any way that I adjust 0.60 Lakhs of LTCG upto my exemption limit of Rs 3.0 (Senior Citizen) and another Rs 2.0 Lakhs of LTCG so as to fall in the bracket of Rs 3-5 Lakhs wherein the tax is 5%. Requesting for your valuable advice.
    Thanking you in advance.
    Col Retd Sushil Kumar Sawhney

    1. Hello Sir, whether it is segregated units or ‘forced redemption’ your understanding on the tax is right. It is unfortunate but it is what it is. On set off etc, please consult your auditor. regards, Vidya

      1. Padmalakshmy Gopalan

        Madam,

        I face the same issue as Col Retd Sushil Kumar Sawhney.

        I refer to this statement of his.

        In the case of segregated debt fund Short Term Income Plan it states the NAV as zero, thereby implying that the cost of acquisition is zero. However in the same statement the main original NAV of the same plan has been reduced marginally.

        I would like to elaborate on the above with the following example.
        Let us assume cost of acquisition (coa) of yes Bank was ₹1; coa of other securities was ₹19. Total cost ₹20. Total NAV ₹25.

        For simplicity sake, let us assume, both the securities appreciated by 25 percent before segregation. So, value of yes Bank was ₹1.25 and value of other securities was ₹23.75 before segregation.

        After segregation, segregated folio has a cost (coa) of zero and a value (nav) of zero.
        The main folio has a cost of ₹20 and nav of ₹23.75.

        For clarity sake, assume main folio is redeemed in full. So capital gain is ₹3.75.
        Also assume, yes Bank at1 bonds is recovered in full. So entire ₹1.25 is fully taxable as coa in segregated folio is zero.

        So, in effect, total capital gains is ₹3.75 plus ₹1.25. ( ₹25 less ₹20 ) equals 5. This is obviously correct.

        But the issue is,
        By reducing cost (coa) in the main folio by ₹0.25 (1.25 nav less 1.00 cost of yes Bank) the capital gains in the main folio is wrongly increased to ₹4 (instead of ₹3.75 as shown above) while at the same time holding that the entire ₹1.25 is taxable in the segregated folio.

        This results in an indirect overall capital gains of ₹5.25 when the actual cost was 20 and the value was 25.

        This was not the intention of the legislature.
        Please refer section 49(2ag) of IT Act, 1961.

        Also, the cost of acquisition as per the Franklin Account Statement is different from the Franklin Capital Gains Statement.
        How can this be?
        A simple check would have ensured, citing the above example, ₹5.25 is not taxed while the maximum possible earnings is ₹5.

        Request you to highlight this anomaly in the Franklin Capital Gains Statement.
        It might seem like a marginal difference.
        But, when translated into thousands of rupees, (nav now is around ₹4300) and thousands of units, the difference is in lakhs and crores. Resulting in an excess tax outflow of 20 percent for long term holdings and at the slab rate (5 percent to 30 percent) for short term holdings.

        Please note that the COA – Cost of Acquisition – referred to above, is before applying the Indexation Factor. So, the difference arises irrespective of whether it is short or long term capital gains.

        To summarise
        Different COA as per Account Statement and Capital Gains Statement arises because ₹5.25 is taxed as capital gains on an earnings of ₹5. resulting in wrongly decreased cost of acquisition and increased capital gains in
        Capital Gains statement.
        But the Franklin Accounts Statement gives the correct picture.

        Intention of the legislature in respect of segregated folios is misunderstood resulting in the above anomaly.
        A simple check like the above example would have prevented this.
        The quantum of difference is irrelevant; eventhough as pointed out above, it can be huge in some cases, resulting in excess tax outflow to the detriment of the investors. What is relevant is that there are no mistakes and the software captures the correct capital gains by ensuring all relevant checks are in place.

        Request you to take it up with Franklin mf for the benefit of all investors.

        Thanks a million.
        Padmalakshmy Gopalan

        1. Hello Sir,

          Franklin segregation of Vodofone units was an outlier case where FT wrote off the whole units to zero BEFORE segregating. hence the trasfer cost was zero. This did not happen with other segregated units. For more clarifications, kindly discuss with your auditor. We are not tax expert. Besides the right forum would be IT dept. and not AMC. Thanks, Vidya

  2. Would the treatment be same for the segregated portion of ABSL Dynamic Bond?

    The fund was sold in Dec 2019. The Account Statement continues to mention unit cost = 0 but current NAV = 1.5150. But I asked for the Capital Gains Statement recently and it reduces purchase cost of main fund – thereby inflating Capital Gains.

    1. yes it is. Franklin’s case was different because they wrote off the paper before segregation. What we explained as segregated units’ tax applies for all others. thanks, Vidya

  3. 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%

  4. 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

  5. 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

  6. 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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