Taxation on Side Pocketed or Segregated Mutual Funds

Recently I wrote an article with respect to Mutual Fund Taxation for FY 2020-21. However, due to the recent Budget 2020, the clarity emerged with respect to Taxation on Side Pocketed or Segregated Mutual Funds.

You can refer my earlier post related to Mutual Fund Taxation for FY 2020-21 (AY 2021-22) at ” Mutual Fund Taxation FY 2020-21 (AY2021-22)“.

In this post let us discuss Debt Funds where due to default or downgrade in the securities the debt fund invested, Mutual Fund Companies create the Side Pocketing or Segregation of Mutual Funds.

I have already written a detailed post on what is side pocketing or segregated mutual funds in India. Refer the same at ” All about Segregation or Side Pocketing in Mutual Funds“.

Below is the table, which explains the current taxation on Mutual Funds in India for FY 2020-21.

However, due to the recent rules with respect to side pocketing or segregation of units of mutual funds created confusion among many investors like what will be the tax treatment with such side pocketed or segregated mutual fund units.

Budget 2020 cleared this doubt and hence let us look into this aspect.

What is Side Pocketing or Segregation of Mutual Funds?

As I already told, I have already written a post on this ” All about Segregation or Side Pocketing in Mutual Funds “. However, for the benefits, I will copy-paste the same here.

Segregation or Side pocketing in Mutual Funds means Mutual Fund Companies separate their bad or risky assets from their liquid assets. This creates a stoppage of sudden fall in NAV due to a few investors’ knee jerk reactions of redemption.  Few features of Segregation or Side pocketing in Mutual Funds are as below.

# You are not allowed to withdraw from the bad portfolio of a fund.

# You are allowed to withdraw and invest in a liquid portfolio.

# You will see two NAVs of a fund. One is for a bad portfolio and another is for the liquid portfolio.

# Division into two Funds (good and bad) will be effective from the date of the credit event.

# No TER or expenses will be charged on the bad portfolio. However, TER (excluding the investment and advisory fees) can be charged, on a pro-rata basis only upon recovery of the investments in a segregated portfolio.

# Any recovery in the Bad Fund (partial or full) will be distributed to the investors in the proportion of their holding in the portfolio.

# All existing investors in the scheme as on the day of the credit event shall be allotted equal number of units in the segregated portfolio as held in the main portfolio.

# As I told above, no redemption and subscription shall be allowed in the segregated portfolio. However, in order to facilitate exit to unitholders in the segregated portfolio, AMC shall enable listing of units of the segregated portfolio on the recognized stock exchange within 10 working days of the creation of a segregated portfolio and also enable the transfer of such units on receipt of transfer requests.

# Any recovery expenses from such a bad portfolio will be charged on such a bad portfolio. However, such legal expenses should not be more than the TER of the fund. If such recovery charges are more than TER, then AMC will bear these additional expenses.

# Mutual Fund Companies can’t charge any recovery expenses on the liquid portfolio.

# Any recovery of the amount of the security in the segregated portfolio even after the write off shall be distributed to the investors of the segregated portfolio.

Now let us take a LIVE example. Adilink Infra & Multitrading Pvt. Ltd., an infrastructure company of the Subhash Chandra-led business house, failed to repay a minority investor on Nov. 25, leading to a default. This forced Aditya Birla Sunlife Mutual Fund company to create a segregated portfolio for three of its Debt Mutual Funds. The current status of these three portfolios is as below.

Birla Sunlife Mutual Fund Exposure to Adilink Infra and Multilink Trading as of 23rd Nov 2019

Let us now see how it created a Segregated Portfolio or Side pocketing to these three mutual funds by taking an example of a fund from these three.Let us consider the example of ABSL Credit Risk Fund and the segregation will be executed as below.

Segregation or Side Pocketing in Mutual Funds

I hope now you got the clarity on how the Segregation or Side Pocketing in Mutual Fund works.

Taxation on Side Pocketed or Segregated Mutual Funds

Now let us jump into the taxation part of this segregation or side-pocketing Mutual Funds, Let us take an example of the above case.

Assume that You have invested Rs.1000 when the NAV was Rs.10 and holding total units of 100. Now assume the same Rs.10 NAV appreciated to Rs.100 on the date of side pocketing. Due to this, the total value will be Rs.10,000.

Now, because of default or downgrade, assume that the segregation was created with Rs.96.5 as GOOD asset and Rs.3.5 as a BAD asset.

Here the ratio of segregation or side pocketing is in the ratio of 96.5% to 3.5%.

Now due to this segregation or side pocketing, if you wished to withdraw the money from a GOOD asset which is currently at Rs.96.5 NAV, then the cost of acquisition is Rs.965 rather than the Rs.1000. Also, the current value as you may be aware will be Rs.9650.

Same will be applicable in the case of BAD assets.

Also, accordingly, the date of acquisition is also the original date of investment rather than the date of side pocketing.

Hence, for the calculation purpose of taxation, the original invested date and also the cost of acquisition will be proportioned as it is segregated between good assets and bad assets.

Hope, it cleared the doubts in the minds of the investors of debt mutual funds.

12 Responses

  1. can the investor claim the entire amount of the segregated portfolio marked down to zero as a capital loss in the year in which such segregation occurs? Subsequently, if the entire or a partial amount is received that amount may be categorised as a capital receipt, which is not taxable OR, as a receipt which is fully taxable since one would have claimed the entire amount as a loss earlier. Will appreciate your commenmts and reference to some case laws which have similar anology.

    1. Dear Ragesh,
      How can you mark down the segregated portfolio as portfolio loss as there no such events happened. AMCs may receive full or partly based on the issuers payments. Hence, I don’t think it is the right strategy to mark down as zero and show as a capital loss.

  2. What happens if ABSL is unable to recover the loans? Will the Segregated Fund remain in the investor’s folio in perpetuity? How would the investor record Capital Loss?

    How is ABSL Dynamic Segregated allowed to mention purchase NAV = 0 (even though Finance Bill, 2020 mentions cost have to be allocated proportionately) and current NAV = 1.3985 (even though it cannot be traded)? It appears misleading.

    Is there any representation made to the Finance Ministry to amend the clause since not only are the investors faced with losses, they also have to pay additional tax on inflated Capital Gains due to lowering of original cost price.

    1. Dear Munish,
      If the whole segregated portfolio became zero, then no question of profit or redemption. It will turn out to be a permanent loss for the investor. However, if there are a partial recovery and partial loss, then the recovered amount is allowable for withdrawal with the loss. The cost of acquisition for the bad asset is the proportionate original cost of acquisation.

    1. Dear Kavaljit,
      Regarding the non-segreagated portfolio, the regular debt fund rules apply. Whether you withdrew any segregated portfolio and there is a capital gain? I think NO. If yes, then also, as per my knowledge, you can apply the above rule.

  3. What is the cost of acquisition of the BAD asset? On the day of segregation it would be 0, as AMC gives it at 0 NAV. When some money is recovered in the future, what is considered the cost of acquisition?
    Could you update your above example with this scenario.

    1. Dear Melwyn,
      The cost of acquisition of such bad units is the original cost of acquisition proportionally divided as how the AMC divide between good and bad portfolio. It does not matter the NAV of the segregated portfolio as you have invested earlier.

  4. Dear Basu,

    What happens if mutual fund gives credit of the amount of Segregated portfolio units after some period. It may happen if they recover the money from segregeted units.

    1. Dear Shrivallabh,
      If AMC receive such amount, then this will be distributed among the existing investors in the same proportion. However, it is up to you to decide whether you wish to hold or continue. If you decided to withdraw, then the taxation will be as I shared above.

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