Introduction
In recent years we have witnessed series of downgrades and collapse of major financial institutions and companies such as ILFS & DHFL which led to liquidity squeeze in debt instruments issued by these institutions and companies as there were no takers of securities issued by these companies due to downgrading of such securities to “Junk” or “Default” category by credit rating companies. This also created problems for debt mutual funds who invested in these securities and their investors as mutual funds were not able to realize these securities and meet redemption pressure from investors of these schemes. These created further volatility in the money market instruments and liquidity problems on one hand as companies were not able to raise short-term funds from the money market and loss to investors of debt mutual funds on the other hand as they were not able to redeem their investments in such schemes.
To tackle this menace SEBI vide its circular no. SEBI/HO/IMD/DF2/CIR/P/2018/160 dated 28 December, 2018 allowed the AMCs to create a segregated portfolio of debt and money market instruments by mutual fund schemes to ensure fair treatment to all investors in case of a credit event and to deal with liquidity risk.
What is Segregated Portfolio
1. Segregated Portfolio: The term ‘segregated portfolio’ shall mean a portfolio, comprising of debt or money market instrument affected by a credit event, that has been segregated in a mutual fund scheme.
2. Main Portfolio: The term ‘main portfolio’ shall mean the scheme portfolio excluding the segregated portfolio.
3. Total Portfolio: The term ‘total portfolio’ shall mean the scheme portfolio including the securities affected by the credit event.
To summarize above and make it easy we can simply say that:
Example:
Let’s suppose you invested Rs.1000 in XYZ debt mutual fund scheme at NAV of Rs.10 per unit that is you will be allotted 100 units in such scheme. Now XYZ fund will invest Rs.1000 in debt securities of various companies as per the investment objectives of such scheme.
Now let’s suppose one fine day there is a downgrade by Credit Rating Agency of debt securities issued by IL&FS, one of the companies in which XYZ scheme invested Rs.50 out of its total portfolio of Rs.1000. As a result XYZ scheme will transfer the exposure to IL&FS of Rs.50 to another portfolio which will be called “Segregated Portfolio” as per SEBI circular (Portfolio comprising of debt securities affected by credit event).
Now remaining portfolio will be called “Main Portfolio” which will comprise the portfolio excluding the segregated portfolio which in our example will be Rs.950 [Rs.1000(Total Portfolio) less Rs.50(Segregated Portfolio)]
XYZ scheme will now have to allot equal no. of units to the existing investors in the segregated portfolio as they hold in the main portfolio(In our example it will be 100 units). Scheme will have to mandatorily disclose the NAV of both main portfolio and segregated portfolio on daily basis.
In future Investors redeeming their units will get redemption proceeds based on the NAV of “Main Portfolio” and will continue to hold the units of “Segregated Portfolio” and Investors subscribing to the scheme will be allotted units only in the “Main Portfolio” based on its NAV.
No redemption and subscription shall be allowed in the segregated portfolio. However, in order to facilitate exit to unit holders in segregated portfolio, AMC shall enable listing of units of segregated portfolio on the recognized stock exchange within 10 working days of creation of segregated portfolio and also enable transfer of such units on receipt of transfer requests.
Taxation of Segregated Portfolio
- What will be the Cost of Acquisition of units in segregated portfolio?
- What will be the Period of Holding of units in segregated portfolio?
- Will the capital gains arise on transfer of units into segregated portfolio from total portfolio?
Finance Act,2020 had put to rest all these uncertainties and ambiguities by making necessary amendments in Income Tax provisions which are discussed as follows:
Issue 1: Cost of Acquisition of Units in Segregated Portfolio and Main Portfolio
Cost of Acquisition (COA) of units in Segregated Portfolio: As per section 49(2AG) of Income Tax Act,1961, the cost of acquisition of 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.
Above provision can be better understood with the help of following formula:
Cost of Acquisition (COA) of units in Main Portfolio: As per section 49(2AH) of Income Tax Act, 1961, the cost of 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 under section 49(2AG).
Issue 2: Period of Holding of Units in Segregated Portfolio
As per section 2(42A)(hh) of the Income Tax Act, 1961, in the case of a capital asset being 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 held by the assessee.
Simply stated the period of holding in the Segregated Portfolio shall be reckoned from the date when the units were originally allotted to the assessee in the main portfolio and not from the date when such segregated portfolio was created.
Issue 3: Whether capital gains will arise on transfer of assets to Segregated Portfolio
No capital gains shall arise to a unitholder on segregation of portfolio as there is no sale exchange etc. of the units of total portfolio before segregation.
Let us understand the above provisions with the help of following example:
Mr. A holds 1000 units in Franklin Templeton Mutual Fund (FTMF). He had bought these units on 01.01.2018 @ Rs.100 each. On 01.05.2020, FTMF segregates the portfolio as one of the investee company, Vodafone-Idea is being downgraded by a credit rating agency and has turned into a bad-debt. By virtue of segregation, Mr. A is allotted 1000 units of segregated portfolio. On date of segregation, NAV of Segregated Portfolio is Rs.400 crores and reduced NAV of main portfolio is Rs.1600 crores (Total NAV was Rs.2000 crores). Mr. A sells 2000 units on 01.02.2021. Now;
- Cost of Acquisition
– Of 1000 units of Segregated Portfolio shall be Rs.20 each i.e. [Rs.100 (Original COA) X Rs.400(NAV of the assets transferred to Segregated Portfolio] / [ Rs.2000 (NAV of the Total Portfolio immediately prior to such segregation)].
– Of 1000 original units of Main Portfolio shall be Rs.80 each i.e. [Rs.100 ( Original COA) (-) Rs.20 (COA of units in Segregated Portfolio)].
- Period of Holding
– Of all the units of Segregated Portfolio as well as the main portfolio shall be reckoned from 01.01.2018 and hence, long term capital gains shall arise on sale of all units.
Author Bio
Segregated Portfolio ….So Simply explained with easy example….Great and Thanks…
A very good article. Leaves a lot ambiguity to rest.