Recent NBFC crisis and downgrading of corporate bonds have affected several mutual funds that invest in debt securities. Interestingly fund houses have reacted very differently. Many are writing down defaulting papers. Some have deferred repayment of maturity proceeds of their fixed maturity plans. One of HDFC mutual fund’s debt schemes sold its affected securities to its AMC thereby protecting investors. Kotak repaid its investors after deducting maturity proceeds attributed to defaulting investments. HDFC MF renewed one of its fixed maturity plans by 12 months.
Earlier this month Tata Mutual Fund, house split its portfolio into two in one of its debt funds. The trigger was a default of interest payment by DHFL an NBFC in news for its troubles these days. Tata mutual fund is the only mutual fund that has made a first formal use of circular issued by SEBI in December 2018. JP Morgan had of course done it some years ago after Amtek default, leading to SEBI formalising and standardising the process to put
checks and balances in the interest of investor protection.
SEBI circular dealing with a mechanism known as ‘side-pocketing’ mechanism allow a mutual fund to segregate the downgraded or bad debt securities from the investment grade securities into a separate scheme with a separate Net Asset Value (NAV). Investors are allotted new units for the new portfolio and as a result the NAV of original units is revised. While the transactions of investments and redemptions or sale continue in the original units, no transactions are allowed in the units of new portfolio till recoveries are made from defaulting companies. However such units are required to be listed to facilitate exit by investors in secondary market, though it is unlikely that much trading will take place in such units.
The scheme as such serves a very meaningful purpose for investors. If the bad portfolio and units are not segregated, then the moment a credit default happens and hence the write-off happens, the NAV goes down and any investor exiting at that NAV will lose the chance of benefit of recovery. If fresh investors come in at written down NAV and then the recovery happens, the new investors gain at the cost of existing investors. Also till the NAV is written down while bad debt is among the portfolio the trading is effectively happening at a ‘wrong’ NAV which not be truly reflective of units worth. One hopes that in coming months more fund houses follow Tata group in adopting good practices in interest of investors.
To give an example of side pocketing, let’s say an investor is holding 1000 units bought at Rs 10 each with a total investment of Rs 10,000 with the current value of Rs 15,000 at the NAV of Rs.15 each. If the exposure of bad debt is say 20%, and a 50% write down of such debt is done (SEBI circular mandates 75% write down), the side pocketing or segregation would be done for portfolio of Rs 3,000 carried forward at written down value of Rs 1,500 i.e. NAV of Rs 1.5 per unit. Original units will have a new revised NAV of Rs 12, with investment worth Rs 12,000. Without side pocketing, all the units would carry a NAV of RS 13.5 and investment valued at Rs.13,500.
Looking at the scale of defaults and the large number of mutual funds having exposure of bad debt paper, it is likely that SEBI will push for better adoption of side pocketing mechanism. Hence it is important to examine if current tax provisions are adequate or any special concessions need to be made.
As such the investors can chose to sell/redeem the original units at any time. They are likely to hold new units till some recovery is made from defaulters. On sale/redemption of either category of units there can be gain or loss for the investor. In case of non-resident investors, the mutual fund is expected to deduct tax before make payment of redemption amount. For all resident investors also the mutual funds are required to provide capital gains statement
for paying taxes filing their tax returns. Hence the fund house also needs to change their systems to do appropriate calculations of capital gains. For these purposes the investors and mutual funds need to determine the cost of purchase of original and new units for tax purposes.
Applying a common sense or a commercial approach, broadly there can be two methods – one where no cost is attributed to new units and the other where cost is allocated to original and new units on some basis. While there is no specific provision that deals with side pocketing, section 55(2)(aa) of Income tax Act, 1961 appears to be closest to deal with the situation. It provides that when on the basis of any financial asset an additional financial asset is allotted to a person without any payment, then for original asset the actual cost should be adopted and for the additional financial asset the cost should be taken as nil. The period of holding of new asset is calculated from the date of allotment of new asset. This provision is often used in the situations of issue of bonus shares. Applying the provision one could simply calculate the tax by deducting entire cost from sale/redemption proceeds of original units, and nothing from redemption proceeds of new units. One can then apply short term or long term capital gains tax on the units taking date of allotment of new units as basis for period of holding of new units.
Further section 94(8) provides that where any person is allotted additional units without any payment on the basis of original units and such person sells original units within a specified timeframe, the loss if any arising on account of such sale shall be ignored and that loss shall be deemed to be the cost of purchase additional units.
Would this mode of adopting cost and calculating gains on original and new units be fair to investors? Similarly, would ignoring loss on original shares be fair if it falls within specified parameters?
It would probably depend on what investors chose to do in terms of priority of exit from original and new portfolio/units. If an investor choses to sell the original units first, the aforesaid provision is beneficial because it allows for deduction of entire cost. If however an investor happens to sell new units first and it happens to be a short term gain which attracts higher tax, one would want to deduct some proportionate cost from such gains because as a
matter of fact it is not that units were allotted as a gift, a part of the cost actually was effectively paid towards such units. Further commercially the investor may be making loss on the transaction because the recovery of bad debt may be lower than 100% or even lower than the written down NAV and hence taxing such an investor on entire proceeds would be grossly unfair. In the worst possible scenario of no recovery at all, the investment (new units) may have to be written off, the loss would not even be counted for tax purposes because there would be no transfer of units.
Hence in author’s view this situation should be compared with a case of a corporate demerger. In a corporate demerger the original cost of shares is allocated over original and new share, based on net-worth of the two businesses which are split. In the mutual fund industry, perhaps the NAV is closest to the concept of networth of a company’s business units and hence a fair allocation of cost could be on the basis of two NAVs, the NAV of original units post side pocketing and the NAV of new units. SEBI regulations do not mention anything about face value of new units probably because it is irrelevant from investor’s angle. So face value as a basis of allocation is anyway not available. Therefore, NAV appears to be most logical and fair basis of allocating original cost.
If this method is given legal sanctity, the numbers would look as illustrated here. Carrying forward the aforesaid example, lets us assume that an investor makes an investment of Rs 10,000 on 1000 units and the current value/NAV is RS 15,000 @ Rs 15 per unit. If such a portfolio had a bad portfolio of pre-write-down value of Rs 3,000, on segregation of bad portfolio, the revised NAV of good portfolio would be Rs 12 (12000 / 1000). If the bad portfolio is written down by 50% (though sebi mandates 75% write-down), the new units would have a NAV of Rs 1.5 (50% of 3000 / 1000). The cost of RS 10,000 will have to split in the ratio of 12 to 1.5 which works out to Rs 8,889 and 1,111. Accordingly the capital gains would need to be calculated and the period of holding for short or long term gains would be determined from the date of purchase of original units for both categories of units.
It can make a substantial difference for investors depending on how calculations are made, apart from the complications in a situation where investor ends up with a loss on original or new units as discussed earlier. Given that the number of mutual funds with exposure to bad debt paper and the investors affected are huge, we are likely to see more instances of side pocketing; the new budget proposals must introduce provisions to deal with the situation.
The mechanism covered by SEBI circular should be treated at par with a corporate demerger. Also, in the worst case of no recovery at on, write off of new units should result in a tax loss that can be adjusted against other gains of investor even if there is no transfer of units. Further, a carve out needs to be made in Section 94(8) which effectively restricts set off loss on original units against other gains under certain circumstances. A carve out is needed because unlike in bonus units or bonus shares, the loss on original units is not because of additional issue bonus issue but because of genuine reduction in intrinsic value of underlying original portfolio along with a possible dip in the value of new units as well. One hope these issues are addressed appropriately in the finance bill to be presented next week.
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