Side-Pocketing Should Be Next Tax Focus

Before the end of 2018, market regulator SEBI issued a circular permitting mutual funds (MFs) to create a segregated portfolio pursuant to a credit event. Called 'side-pocketing' in industry parlance, this is prevalent globally. The reason for such relaxation could be the recent NBFC crisis, which sparked panic among investors. However, there is little clarity regarding tax implications of such a measure that seeks to address investors' concerns.

Side-pocketing means the creation of a segregated portfolio of debt or money market instruments, affected by a credit event, specifically separated in an MF scheme. Such segregation of distressed assets is required primarily to ring-fence liquid assets or deal with liquidity risk and reduce panic redemption by investors. It is optional for MFs and is permitted, subject to:

• Happening of a credit event at the issuer level, i.e., a downgrade in credit rating by a SEBI-registered credit rating agency to 'below investment grade' or lower or similar such downgrade of a loan rating;
• Trustees' approval, which should be obtained within one business day from the day of the credit event;
• Scheme Information Document provided for such segregation with adequate disclosures;

Key Mechanics of Side-pocketing

1. It shall be effective from the day of the credit event.
2. Two NAVs, one of the segregated portfolio and other of the main portfolio (excluding the segregated portfolio), shall be disclosed.
3. Existing investors as on the day of the credit event shall be allotted an equal number of units in the segregated portfolio (bad units) as held in the main portfolio.
4. Units shall be listed within 10 working days of side-pocketing.
5. Redemption and subscription shall be suspended in the segregated portfolio. Existing investors can exit by transferring units on a recognised stock exchange.
6. Post-segregation, investors will be allowed to redeem units of the main portfolio (good units) and will continue to hold the bad units.
7. After side-pocketing, new investors in the scheme will be allotted good units only.
8. Any future recovery of bad assets shall be distributed to investors in proportion to their holding in the segregated portfolio.
9. There is no restriction on creation of more than one segregated portfolio based on credit events.

Tax Implications

The I-T Act contains specific provisions to give tax neutrality to certain corporate events such as amalgamation and demerger and also contains specific provisions for MFs. But the current law does not contemplate MF side-pocketing. Here are the probable tax implications arising out of side-pocketing of bad assets:

• Cost of bad units and holding period: Investors are allotted bad units without any additional payment. As per Section 55(2)(aa)(iiia), the cost of financial assets allotted without any payment and on the basis of the holding of other financial assets shall be Nil. Similarly, as per relevant provisions of Section 2(42A), the period of holding bad units could be considered from the date of allotment of such units. The said provisions were introduced to ascertain the cost for bonus shares and securities. Bad units are not akin to bonus shares.
• Logically investor should be allowed to spread the cost of acquisition of original units between good and bad units. Before the introduction of Section 55(2)(aa)(iiia), courts have held that the cost of bonus shares should be determined by spreading the cost of original shares between bonus and original shares. The approach adopted to determine the cost of bad units would also impact the cost of good units.
• Application of other provisions such as Section 56(2)(x), applicable when a person receives any property without consideration, and Section 94(8), meant for bonus-stripping transactions, to side-pocketing could also give unintended results.

Finally, SEBI's decision to adopt this concept is welcome and should act as an enabler for the MF industry. Now, the authorities should also address the tax implications of side-pocketing.

Radhakishan Rawal is Partner and Geeta Bhatia is Senior Manager with Deloitte Haskins & Sells