This is the time of the year when mutual funds launch fixed maturity plans (FMPs) to which investors eagerly subscribe on account of “double indexation” benefits.
Much of the sheen of FMPs was lost in October 2008 on account of the liquidity crisis faced by mutual funds. The rush to prematurely encash such units was triggered off by fear of bond defaults by companies in which FMPs had invested. The Securities and Exchange Board of India (Sebi) has now mandated listing of FMPs and has sought to regulate the portfolio of such plans, resolving the problem to some extent.
If you are a taxpayer in the highest tax bracket, who is looking at long-term investment, FMPs make a lot of sense on account of the higher yield due to the tax benefit. So, what is this tax benefit and how does it affect your yield on such plans?
Let us assume that an 18-month FMP launched in February 2010 would yield a return of about 7-7.5%, almost the same as that given by bank fixed deposits. If you opt for the FMP’s growth option, on an investment of Rs1,000, you would get around Rs1,112.50 on maturity in August 2011. The appreciation of Rs112.50 is treated as a capital gain and since the units are held for more than 12 months, the gain is a long-term capital gain.
In computing long-term capital gains, one is entitled to claim indexation of cost. The cost index is normally worked out so as to neutralize 75% of consumer inflation. Assuming that consumer inflation is at 12% for the fiscal year 2009-10 as well as for 2010-11 (a likely scenario given that food inflation is currently at almost 18%) and given the cost index level of 632 for the current year, the index would most probably be notified at about 689 for the fiscal year 2010-11 and about 751 for the fiscal year 2011-12. Since the year of acquisition is 2009-10 and the year of maturity is 2011-12, you would be entitled to a cost indexation for two years, what is commonly referred to as “double indexation”, of about 18.8% (751/632) for the units. The capital gains would be negative since your maturity proceeds would only be Rs1,112.50, while the indexed cost would be Rs1,188.
Effectively, therefore, your return of 7-7.5% would be tax-free as opposed to a 30.9% tax that you would have paid on the interest income on your bank fixed deposits or bonds. In effect, the manner of mutual fund income taxation permits you to get the benefit of converting the interest income earned by the mutual fund into your capital gain.
The benefit of capital gains is only in cases where the FMP is for a period of more than 12 months. Even with single (one-year) indexation, one may end up paying nil or negligible tax. For short-term FMPs (which have now almost vanished on account of the listing requirement), the regular income option may be more advantageous than the growth option.
If you opt for a regular income option of an FMP, the income distributed by the mutual fund would have been subject to an income distribution tax of 14.16% payable by the mutual fund, and the income received would have been tax-free in your hands. Though this tax is paid by the mutual fund, it effectively is being borne by you as the mutual fund would reduce the income distribution payable to you by an amount equivalent to the tax being paid on your income distribution. Instead of 7.5% which may have been paid under the growth option, the income distribution may be about 6.44%, which would be tax-free. The tax on your income is, therefore, only 14.16% against 30.9% payable on interest on bank fixed deposits or bonds or on your short-term capital gains.
The choice of your investment in FMPs would, therefore, be driven by your liquidity needs, your tax bracket and the duration of the FMP.
But before you rush to invest in an FMP, a word of caution. The direct taxes code (DTC) is likely to come into effect from 1 April 2011. The draft DTC indicates that cost indexation would be available only from the year following the year of investment. Also, mutual funds are proposed to be treated as pass-through entities (in simple words, you would be taxed in the same manner as the income of the mutual fund would have been taxed in its hands). While there is an exemption for income arising in respect of mutual fund units, that seems to be a drafting error. When your FMP matures in August 2011, you may find that the tax treatment is different. In that case, you may need to sell the units before the DTC comes into effect (maybe to your spouse), so as not to lose the tax benefits.
Gautam Nayak is a chartered accountant. Your comments, questions and reactions to this column are welcome at firstname.lastname@example.org