Franklin Debt MF: Vodafone Idea Payment (Segregated Portfolio): How will it be taxed in your hands?

There was a happy surprise for investors in Franklin Ultra Short Bond Fund recently.

In January 2020, the AMC had side-pocketed its investments in Vodafone Idea bonds.

In June 2020, Vodafone Idea made interest payment on these bonds and you would have received some payment. On July 10, 2020, the 8.25% Vodafone Idea Ltd. bond matured, and Franklin schemes received the full payment on the said bond. The AMC duly passed on the receipts to the investors. Given that Vodafone Idea’s finances are stretched, and its survival seems to be under threat due to AGR dues legal battle, this is no small relief for the investors.

Note: The side-pocketing of Vodafone Idea bond issue is not related to the winding up of a few Franklin debt MF schemes, including Franklin Ultra Short Bond Fund, in April 2020. Vodafone Idea has repaid the full dues to scheme and the AMC has transferred money to your account and extinguished all the units in the segregated portfolio.

Your money in Franklin Funds at the time of winding up of these schemes is still stuck. There are now some legal challenges to the entire exercise.

Read:  What is Side-pocketing? How it helps?

How will such proceeds from the Franklin Ultra Short Segregated Portfolio be taxed?

I have written about the taxation of proceeds from the segregated portfolio in detail in this post.

To recap:

1. Payment from segregated portfolios are made through redemption of units.
2. The cost of acquisition in the segregated portfolio shall be = NAV of the troubled asset immediately before side-pocketing/NAV of the Fund immediately before side–pocketing
3. Holding period shall be calculated from the date of original purchase and not from the date of side-pocketing.

I have explained all the steps through an illustration in this post.

The way Franklin AMC handled Vodafone Idea bond downgrade has made at least the capital gain calculation part quite simple.

In January 2020, Franklin Ultra Short Bond fund wrote off the entire value of Vodafone Idea bond to zero (following adverse legal outcome on AGR dues, and before the downgrade) and the NAV went down by over 4 percent in a day. After a few days, the Vodafone Idea bond was downgraded, and the exposure was side-pocketed.

Therefore, immediately before the side-pocketing, the NAV of the troubled bond in the portfolio was zero. Hence, the cost of acquisition of units in the segregated portfolio in this case shall be considered zero (Refer to pt.2).

Thus, the entire proceeds from Franklin Ultra Short bond Fund-8.25% Vodafone Idea-Segregated portfolio shall be considered capital gain.

Long Term or Short-Term Capital Gain?

Depending on your marginal income tax rate, this can be quite important.

For an investor in the 30% tax bracket, this capital gain (if it is short term) shall be taxed at 30% (before cess and applicable surcharge). On the other hand, if the capital gain is long term, this shall be taxed 20% after indexation. Depending upon Cost of Inflation Index (CII) levels announced by the Government, this can vary. Relying on the recent experience (low inflation), this can be around 10-15%. Cess and surcharge shall be extra.

Since we are talking about a debt fund, the resulting gains shall be considered short term if the holding period is up to 3 years. The resulting gains shall be considered long term capital gain if the holding period is more than 3 years.

Refer to pt. 3 in the previous section.

The date of purchase of units in the segregated portfolio shall be the date of purchase in the main fund. Let us understand with the help of an example.

Scenario 1

You invested in Franklin Ultra Short Bond on July 15, 2016.

Vodafone Idea exposure was moved to a segregated portfolio on January 24, 2020.

In this case, the date of acquisition of units in the segregated portfolio shall be July 15, 2016 (and not January 24, 2020).

The sale date shall be the date of redemption of units. In this case, it is June 15, 2020 for the interest payment last month and July 10, 2020 for the more recent payment.

Since the cost of acquisition is zero and the holding period is more than 3 years, the entire proceed from the Franklin Ultra Short Bond fund shall be considered long term capital gain and taxed accordingly.

Scenario 2

You invested in Franklin Ultra Short Bond on July 15, 2018.

The date of acquisition shall be July 15, 2018.

Since the holding period is less than 3 years, the gains shall be considered short term capital gain.

Other scenarios

You invested on June 25, 2017.

The payment (due to interest payment from Vodafone Idea) on June 15, 2020 shall be considered short term capital gain.

The payment (due to full principal and interest payment from Vodafone Idea) on July 10, 2020 shall be considered long term capital gain.

As an investor, the determination of holding period can become quite cumbersome, especially you have bought or sold into the fund many times. You must decide for each investment in the fund whether the resulting units in the segregated portfolio are long term or short. Mutual fund redemption works on First-in-First-out (FIFO) basis. Therefore, if you have been selling too, be ready to spend more time working out all the data.

Alternatively, you can download the capital gains statement from Franklin website or use third-party or investment software to calculate your tax liability.