How Mutual Fund Sidepockets are taxed?

I have written about side-pocketing of debt mutual fund in a previous post. We discussed the pros and cons. One topic we didn’t discuss in that post was the taxation of proceeds from side pockets or segregated portfolios.

In this post, we take a stepwise approach to understand how proceeds from MF side pockets or segregated portfolios are taxed.

If you were an investor in Franklin Ultra Short Bond Fund in January 2020, you would have received an e-mail from Franklin AMC that the scheme has received a payment from Vodafone-Idea and this money shall soon be distributed to you. For the background, in January 2020, Franklin AMC wrote off and subsequently side-pocketed the Vodafone Idea bond exposure. NAV moved by about 4.5% in a single day (though it seems like a non-event after the Franklin Schemes winding up in April 2020). 

How will this payment be taxed? 

Is this money distributed as a dividend or paid through the redemption of units? 

If it is through redemption, how many units shall be redeemed? What shall be the acquisition cost of the units in the segregated portfolio? What shall be the sale price? How does this affect the acquisition cost of units in the main (good) portfolio? All this affects your tax liability.

Which date shall be considered to calculate the holding period, the date of the original purchase or the date of sidepocketing? 

Let’s find out answer to all the above questions in this post.

Taxation of Side-pockets or Segregated portfolios in mutual funds

Finance Act 2020 added two important clauses that are pertinent to taxation of side pockets.

Copying an excerpt from Section 2 of the Income Tax Act

Clause (42A) Sub-clause (hh)

in the case of a capital asset, being a unit or units in a segregated portfolio referred to in sub-section (2AG) of section 49, there shall be included the period for which the original unit or units in the main portfolio were held by the assessee;

This clause ensures that your holding period will be counted from the date of your original investment and not from the date of segregation (side-pocketing). Good for you.

Copying an excerpt from Section 49 of the Income Tax Act

(2AG)The cost of acquisition of a unit or units in the segregated portfolio shall be the amount which bears, to the cost of acquisition of a unit or units held by the assessee in the total portfolio, the same proportion as the net asset value of the asset transferred to the segregated portfolio bears to the net asset value of the total portfolio immediately before the segregation of portfolios.

(2AH) The cost of the acquisition of the original units held by the unit holder in the main portfolio shall be deemed to have been reduced by the amount as so arrived at under sub-section (2AG).

This tells you how to assess the cost of units in the segregated portfolio (side-pocket).

Let us understand the calculations in a stepwise manner.

Step 1: Your investment

Let’s say you invested Rs 1 lacs in a debt mutual fund on April 20, 2017. At the time of purchase the NAV is Rs 20. You receive 5000 units in the MF scheme.

Step 2: Side-pocketing

On January 14, 2020, the NAV of the fund scheme was Rs 30.

On January 15, 2020, there is a downgrade/default in one of the underlying bonds. At the time, the bond forms 4% of the fund portfolio at current valuations.

The AMC side-pockets the troubled exposure.

The NAV of the main portfolio (good portfolio) shall be Rs 30 – 4% of 30 = Rs 28.8 on January 15. I assume the valuation of the remainder of the portfolio does not change from January 14 to January 15.

The NAV of the segregated portfolio shall depend on the write-off that the AMC has decided to take (before the investment is sidepocketed). In case the AMC has written off the entire amount, the NAV of the segregated portfolio shall be 0. Had the AMC written off only 50%, the NAV would be 4% * 30* 50% = 0.6. Let’s say, in this example, the AMC didn’t write off anything before creating the side-pocket.  Hence, the NAV of the segregated portfolio shall be Rs 4%* 30* 100% = Rs 1.2. This aspect is important for capital gains calculation.

Now, you have 5000 units in the main portfolio and 5000 units in the segregated portfolio.

Step 3: Recovery of money

On June 1, 2020, the scheme receives some money (Rs 25 crores) from the troubled bond (company).

Total money receivable from the company = Rs 100 crores

“Total Money Receivable” includes the entire interest and principal repayment that is expected from the troubled bond.

Pay-outs from segregated portfolios are made through the redemption of units.

How many units will be redeemed?

% of your units redeemed= Amount received/Total money receivable from the troubled bond

=25 crores/100 crores = 25%

You hold 5,000 units in the segregated portfolio. 25% of your units will be redeemed. Hence, 1250 of your segregated fund units will be redeemed and your bank account credited.

At what price will the units be redeemed?

Applicable NAV for the segregated unit will be equal to

=Total Money receivable from the troubled Bond/No. of units in the segregated portfolio

We have already assumed the “Total Money Receivable” at Rs 100 crores. Let’s assume further total units in the segregated portfolio are 75 crores. Hence, the applicable NAV will be Rs 1.33 per unit.

You will get 1,250 X 1.3333 =Rs 1,662.5

The same process will apply as and when the AMC receives money from the troubled bond in the future.

Remember if you bought the units in the segregated portfolio from the secondary market, your date of acquisition will be your date of purchase.

Step 4: Calculation on capital gains tax liability

Cost of acquisition of segregated portfolio (Purchase NAV) is equal to

= (NAV of segregated portfolio before side pocketing/NAV of total portfolio) X Acquisition NAV in the original fund

= (Rs 1.2/Rs 30) * (Rs 20 per unit) = Rs 0.8 per unit

Since the purchase NAV will vary depending on your date of purchase, acquisition NAV in the original fund will be different for different investments. The acquisition NAV will be different for each tranche of investment by the same investor.

In the example considered, you got back Rs 1.3333 per unit.

Hence, your capital gain is 1,250 X (1.3333 – 0.8) = 666.63

Note: The purchase NAV for main fund units will go down by Rs. 19.2 (Rs 20 – 0.8). You must use this revised NAV for calculation of capital gains from redemption in the main fund.

Is this gain short term or long term?

You made the original investment on April 20, 2017. The payment from the segregated fund is made on June 1, 2020. Since the investment has completed 3 years, the resulting capital gain shall be considered long term capital gains. You will have to pay tax at 20% after indexation.

The date of side-pocketing is irrelevant for the purchase of calculating the holding period.

What happens in Vodafone-Idea case?

If you were an investor in Franklin Ultra Short Bond Fund scheme in mid-January 2020, you would have received an e-mail recently from Franklin AMC about the receipt of interest(coupon) under 8.25% Vodafone Idea July 2020 bond.

Refer to these 2 notices from Franklin Notice 1 Notice 2

In simple words, the AMC has received interest payment from the Vodafone Idea. Now, this interest payment needs to be distributed among the unitholders (of the segregated portfolio).  As mentioned earlier, the distribution of money received happens through the redemption of units.

I copy an excerpt from Franklin e-mail

Illustration:

• Total amount receivable from 8.25% Vodafone Idea Ltd. (10-July-2020) (includes principal & interest): INR 1355.59 crore
• The above includes:
  • Interest for the period 12 June 2019 to 11 June 2020 and received on 12 June 2020: INR 102.71 crore
  • Interest for the period 12 June 2020 to 9 July 2020 receivable along with principal on 10 July 2020.
• Proportion of coupon received on 12 June 2020 as % of total amount receivable: INR 102.71 crore/ INR 1355.59 crore = 7.58%.

Hence, 7.58% of your holding in the segregated fund will be liquidated at Rs 1.4325 per unit and deposited in your bank account.

Here is an interesting point.

The NAV of the main portfolio (Franklin Ultra Short Bond Fund-Direct-Growth) had gone down by Rs 1.23 on January 16, 2020. Hence, you would have expected that, in the event of full payment, your units in the segregated portfolio will be redeemed at Rs. 1.23 per unit.

However, if you look at Franklin Notice (or e-mail), you will notice that the applicable NAV (for Direct-Growth) is Rs 1.4325.

You will get more than you lost. Strange, isn’t it?

How is that possible?

This happened because Franklin had valued the bonds at higher yields (higher than the coupon rate). Higher yield means lower price than the face value.  As on December 31, 2019, Franklin Ultra Short owned 7,990 bonds of Rs 10 lacs face value 8.25% Vodafone Idea bonds (Rs 799 crores). This bond pays interest on an annual basis (in June every year).

In the normal course of things, the investment would have been valued at over 800 crores (due to accrued interest). However, as per portfolio disclosure on December 31, 2020, the investment was valued at Rs 722 crores. That means that Vodafone Idea had either written off a portion of investment or the market yields for the bond were higher.

Now, if Vodafone Idea pays back the entire amount, you would get much more than Rs 722 crores. In fact, you will get Rs 799 crores + interest amount.

And this explains why you get Rs 1.4325 per unit while your NAV went down by just Rs 1.23 per unit.

What about the taxation of redemption of segregated units in Vodafone Idea bonds?

In the example we considered earlier in the post, the segregated portfolio has non-zero acquisition cost (purchase NAV>0).

In this case, the Franklin AMC wrote down the investment in Vodafone Idea to zero on January 16, 2020.

The side-pocketing happened only a week later on January 24, 2020. Hence, on the day of side pocketing, the value (NAV) of the troubled portion was already zero. The scheme had written off the entire investment on January 16, 2020.

Hence, the acquisition cost of segregated units shall be 0 in this case.

The acquisition cost of units in the main portfolio will be actual cost of purchase (since subtracting zero acquisition of segregated portfolio from it does not change the cost).

Therefore, any amount received from Franklin Ultra Short Bond Fund-Segregated portfolio-Vodafone Idea shall be considered capital gain.

Whether this capital gain is long term or short term, that depends on your holding period.

To calculate the holding period, your original date of investment shall be considered (and not the creation of side pocket/segregated portfolio).

So, if you invested in Franklin Ultra Short Bond Fund on January 30, 2017, your holding period as on June 15, 2020, is already over 3 years and the resulting gain will qualify as long term capital gain.

If you have invested on September 30, 2017, the holding period shall be less than 3 years and thus shall be considered short term capital gain.