Taxation of segregated portfolio simplified

In December 2018, SEBI allowed creation of segregated portfolio in mutual fund schemes, popularly known as side pocketing. It means segregating a bad apple from a debt fund portfolio and putting it in a separate basket, so that the main basket does not look bad.

Since there have been multiple defaults, a few mutual funds have resorted to side-pocketing as it cleans the main portfolio and ensures that recoveries are passed on to only those investors who suffered the default. As and when any recovery happens in the segregated portfolio, fund houses transfer the proceeds to unit-holders.

Taxation aspects

Initially, there was confusion about taxation of proceeds from recovery in the side-pocketed portfolio. If fund house incorporated side pocketing in a scheme, the date of acquisition of segregated portfolio was the date of creation of main portfolio and segregated portfolio.

However, the finance minister gave clarity on taxation of proceeds from side pocketing in the Union Budget 2020. According to the taxation norms, the original date of acquisition of main portfolio will be considered as date of acquisition for taxation purposes in in the segregated portfolio. If you purchased units on say March 31, 2017 and segregation happened on March 31, 2020, for taxation purposes, your date of acquisition will be March 31, 2017.

Another key development was computation of cost of acquisition of units in segregated portfolio.  The cost of acquisition of units in segregated portfolio will be the ratio of value of defaulted units and total value of the main portfolio. Simultaneously, the cost of acquisition of units in the main portfolio will be reduced to the extent of cost of acquisition in the segregated portfolio.

Let us say the NAV of a scheme is Rs 100. Of this, Rs.5 goes becomes Rs.1 due to default. The value of the portfolio becomes Rs 96. Now, fund house creates segregated portfolio. Here the cost of acquisition of units in the segregated portfolio will be Re 1/ Rs 96 i.e. Rs.0.1041 and the cost of acquisition of units in the main portfolio will be reduced by that amount i.e Rs.95.9895 for taxation purposes.

Complications

There are some practical complication related to taxation of side pocketing.

In the above example, Rs 5 goes bad and cost of acquisition has brought down to almost zero after segregation. If your holding period is more than three years, you are eligible for indexation for long-term capital gains. However, it is practically not possible to avail indexation benefit in segregated portfolio, as zero multiplied by any number (indexation number) would be zero.

On the other hand, investors may be benefited due to piecemeal recovery in segregated portfolio. In the above example, the value of Rs.5 becomes Rs.1 due to default. If the fund house recovers 40 paisa, you do not have to pay tax as the value of segregated portfolio is higher. If recovery happens twice, say 20 paisa and 15 paisa in 2 instalments, you still need not pay the tax. Even if the recovery happens in the next financial year, the value of units on the date of creation of segregated portfolio will not change. It is possible that your clients end up paying no taxes if the recovery is less than the original value of units at the time of creation of segregated portfolio.

Debtguru Joydeep Sen is a corporate trainer and author

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