Capital gains on transfer of market-linked debentures, specified mutual funds or unlisted bonds or debentures

Introduction

Any gain arising from the transfer, redemption or maturity of a unit of specified mutual funds, marked-linked debentures or unlisted bonds or debentures is treated as short-term capital gains. Such short-term capital gains shall be taxable at the rate applicable to the assessee.

1. Scope of provision of Section 76

Section 76 contains provisions for the computation of capital gains arising from the transfer or redemption or maturity of the following capital assets:

(a) Market Linked Debenture ("MLD");

(b) Specified Mutual Fund ("SMF"); or

(c) Unlisted Bond or Unlisted Debenture

1.1. Market Linked Debentures

Main article: Market Linked Debentures

MLD is a security which has an underlying principle component in the form of debt security, and where the returns are linked to the market returns on other underlying securities or indices and includes any security classified or regulated as an MLD by the SEBI.

1.2. Specified Mutual Funds

Main article: Capital gains on transfer of mutual funds

Specified mutual fund is a mutual fund that invests more than 65% of its total proceeds in debt-based securities, such as debt instruments and money market instruments. Thus, Gold ETFs, Gold Mutual Funds, foreign index funds, etc., are not considered specified mutual funds. Additionally, the definition will include funds that invest 65% or more in another similar mutual fund. As a result, the fund of funds where the underlying fund primarily invests in debt-based securities will also fall under this definition.

In the Income-tax Act, the taxation of capital gains arising from the transfer of units of mutual funds is based on the proportion of the fund's investments in equity and equity-related instruments compared to its total proceeds. This classification is important because tax implications differ for equity-oriented and non-equity-oriented funds. The taxation scheme of mutual funds shall be as under:

(a) If a mutual fund invests 65% or more of total proceeds in the listed equity shares, the long-term capital gain shall be taxable under Section 198 and short-term capital gain shall be taxable under Section 196;

(b) If a mutual fund invests 35% or more but less than 65% of total proceeds in the equity shares of domestic companies, the long-term capital gains shall be taxable under Section 197 and short-term capital gains shall be taxable at applicable tax rates;

(c) If a mutual fund invests 65% or more of its total proceeds in debt-based securities, then the capital gains shall be taxable under Section 76.

(d) In other cases, the long-term capital gains shall be taxable under Section 197 and short-term capital gains shall be taxable at applicable tax rates.

1.3. Unlisted Bonds or Unlisted Debentures

Bonds and debentures are debt instruments issued by entities to raise capital for long-term financing, typically offering a fixed rate of interest to investors. The income generated from bonds or debentures is generally classified as interest income, which is taxed at applicable rates rather than the concessional rates that apply to long-term capital gains.

To take advantage of the concessional tax rates on long-term capital gains, many taxpayers defer income from bonds or debentures, receiving it as capital gains upon redemption, maturity, or transfer. This strategy is particularly common in the unlisted securities market. To plug this loophole, Section 76 provides that for any unlisted bond or unlisted debenture that is transferred, redeemed, or matures on or after 23-07-2024, the entire consideration (after deducting the cost of acquisition and transfer expenses) shall be treated as capital gains from the transfer of a short-term capital asset, regardless of the holding period or capital gains computation provisions. This curbs the scope of tax arbitrage because short-term capital gain is also taxed at the applicable rates.

2. Date of applicability of Section 76

See also: Taxation of MLDs and specified mutual funds until the tax year 2023-24

Section 76 of the Income-tax Act, 2025 (ITA 2025) corresponds to Section 50AA of the Income-tax Act, 1961 (ITA 1961). Its applicability varies depending on the nature of the asset. In the case of market-linked debentures (MLDs) and unlisted bonds or debentures, the provision operates retroactively, i.e., taxation is determined based on the date of transfer, redemption, or maturity, irrespective of the date of acquisition. In contrast, the provision applies prospectively to specified mutual funds (SMFs) and covers only those acquired on or after the prescribed date. Since the Income-tax Act, 2025, including section 76, comes into force from 01-04-2026, its applicability needs to be understood in the context of how section 50AA operated under the Income-tax Act, 1961.

3. Computation of capital gains from MLDs or SMFs

To compute capital gain, a capital asset is bifurcated into a short-term and a long-term capital asset based on the period of holding. However, irrespective of the period of holding, the capital gains arising from the transfer, redemption or maturity of MLDs or SMFs or unlisted bonds or unlisted debentures shall be taxable as short-term capital gains.

The short-term capital gains from MLDs or SMFs or unlisted bonds or debentures shall be computed in the following manner:

4. Factors for calculation of capital gains

4.1. Full value of consideration

In different scenarios of transfer, the full value of consideration shall be computed as under:

4.1-1. In case of transfer or maturity or redemption

The consideration received or accruing as a result of the transfer, redemption or maturity of MLDs or SMFs or unlisted bonds or debentures shall be deemed to be the full value of consideration.

4.1-2. In case of transfer by way of exchange

If an MLD or SMF or unlisted bond or debenture is exchanged for another asset or the consideration is received in kind, then the fair market value of the asset obtained shall be treated as the full value of consideration. However, where the consideration is not ascertainable or cannot be determined, then the fair market value of the asset transferred shall be deemed to be the full value of the consideration as per Section 80. Section 76 neither provides the method of computation of fair market value nor gives power to the CBDT to prescribe it, unlike Section 79 or Section 77.

Thus, in view of Section 2(44), the fair market value shall be the price that it would ordinarily fetch on sale in the open market on the relevant date.

4.2. Cost of acquisition

4.2-1. In general

In a general situation, the cost of acquisition of a security held in Demat form is computed using the FIFO method under Section 67(7). This method applies for the purpose of computing capital gains under Section 72 and period of holding under Section 2(101).

However, Section 76 provides a special mechanism for the computation of capital gains from MLDs and SMFs or unlisted bonds or debentures. It does not take reference of the mechanism provided in Section 67(7). If it is assumed that such omission is unintentional, the cost of acquisition and the period of holding shall be computed as per the FIFO method. If a contrary view is taken that such omission is intentional, in the absence of any guidance in Section 76, the investor might use either the FIFO method or the weighted average method, whichever is more beneficial. In the FIFO method, the MLDs or SMFs or unlisted bonds or debentures acquired last will be taken to remain with the assessee, while MLDs or SMFs or unlisted bonds or debentures acquired first will be treated as sold. In the weighted average method, the cost of acquisition of the MLDs or SMFs or unlisted bonds or debentures sold is the weighted average price of all his holdings at the time of sale.

4.2-2. Acquired from previous owner

The cost of acquisition of the MLDs or SMFs or unlisted bonds or debentures acquired from the previous owner shall be computed as per the provision contained in Section 73.

4.2-3. No foreign exchange fluctuation

The option available under Section 72(6) to compute capital gains in the foreign currency utilised to purchase the MLDs or unlisted debentures, then convert it into Indian currency shall not be available. Thus, where a non-resident assessee acquires MLDs or unlisted debentures in foreign currency, the capital gain arising from the transfer of such shares or debentures shall be computed in Indian currency directly.

4.2-4. No deduction for the cost of improvement

In relation to the MLDs or SMFs or unlisted bonds or debentures, the cost of improvement shall be taken to be nil, notwithstanding whether it has been incurred by the assessee himself or by the previous owner.

4.2-5. No adjustment under Section 67(10)

Where an amount is charged to tax as income of the partnership firm under Section 67(10), the firm can attribute such amount to the capital asset remaining with it. At the time of computation of capital gains from the sale of such capital asset remaining with the partnership firm, such attribution is allowed by way of deduction under Section 72(5). No such adjustment shall be allowed while computing the capital gains from the transfer of MLDs or SMFs or unlisted bonds or debentures.

4.3. Expenditure incurred in connection with the transfer

Any expenditure incurred wholly and exclusively in connection with the transfer, redemption or maturity of an MLD or SMF or unlisted bonds or debentures shall be allowed as a deduction while computing capital gain. Thus, the brokerage or commission, stamp duty, registration fee, legal expenses, etc., incurred in connection with the transfer, redemption or maturity shall be allowed to be deducted in computing capital gain. However, no deduction shall be allowed in respect of any sum paid on account of Securities Transaction Tax.

5. Tax rate on capital gains from MLDs, SMFs or unlisted bonds or debentures

The return from MLDs or SMFs or unlisted bonds or debentures arising on transfer, redemption or maturity shall be taxable as a short-term capital gain. No concession in the tax rate is available to tax such short-term capital gains, and it shall be taxed as per the tax rate and surcharge applicable to the assessee.

This article is general information and not tax advice. Provisions change. Confirm your position with a qualified professional before acting.