Is it the end for fixed maturity plans?

The 9.74-trillion Indian mutual funds (MF) industry got a rude shock last Thursday, 10 July, when the government’s first Union Budget was presented. Budget 2014 states that investments held in non-equity schemes would qualify for long-term capital gains only after three years (36 months), up from a year earlier. Also, earlier, investors who withdrew money from non-equity schemes were allowed to choose between taxation of 10% (without indexation) and 20% (with indexation). The choice is gone; now it’s just 20%. Here’s what all these changes could mean for your funds and what you can do.

Lower post-tax returns

First, it’s not just your debt funds. The budget speech clearly mentioned “other than equity-oriented funds”. This means, the new provisions will relate to debt schemes, monthly income plans, international funds, gold funds, fund of funds schemes, and so on.

Second, your investments in fixed maturity plans (FMP), especially those that offered double indexation benefits- and short-term debt funds, may be the worst affected.

Assume you had invested in a double-indexation FMP on 25 March 2014, just before the financial year ended, and one that offers a yield of 9.50%. Say, that the FMP will mature on 5 April 2015. Double indexation is an accounting standard whereby the cost price of your FMP gets inflated every year (twice in this case and because of inflation) in such a way that at the time of redemption—and just on paper—your cost price is more than the selling price. Therefore, on paper, you show a loss. No profits means no taxes to pay. But in reality, the FMP earns good returns.

An investment in this FMP would give you a post-tax yield of 9.50% because you don’t pay any tax on your gains. Since the FMP crosses two accounting years, the cost price is inflated twice—in simple words, double indexation. Had you invested the same money in a bank fixed deposit with 9.50% interest, you would have earned a post-tax return of just 7.55%. Why lesser? Because you’d have to pay taxes.

High net worth individuals will get hit the hardest.

The fallout

Fund managers claim that the decision to move the short-term capital gains cut-off to three years and to cut the tax arbitrage that debt funds enjoyed over bank FDs was driven by the Urjit Patel committee report that had highlighted this tax advantage. While the report had mentioned just FMPs, the finance minister covered all non-equity funds.

“FMPs of one or two years duration are likely to be most affected. A substantial part of these FMPs are invested in bank certificates of deposit. We may see investors move from FMPs to certificate of deposits directly. We would also see investors moving into open-ended short-term funds as an alternate to FMPs as these offer active management,” said R. Sivakumar, head, fixed income, Axis Asset Management Co. Ltd.

A fund manager of a foreign fund house said that “one must remember that tax rates are valid from budget to budget. The FMPs were marketed for tax arbitrage rather than as debt investment”.

However, Manoj Nagpal, chief executive officer, Outlook Asia Capital, a Mumbai-based wealth management firm, said that the removal tax arbitrage wasn’t the only problem. “The main problem is that the change in taxation is happening mid-way. Those who had invested recently based on a certain premise, will have to do a mid-course correction,” said Nagpal.

What should you do?

If you are invested in a liquid fund or an ultra short-term bond fund, life goes on. These funds were anyways meant for horizons of less than a year.

Meanwhile, here’s the impending reality. “FMPs of one to slightly more than two years’ tenors will stop completely. A window of opportunity available to retail investors to earn good post-tax returns would now be closed,” said Mumbai-based financial adviser Suresh Sadagopan.

He suggests that for tenors of 1-3 years, short-term debt funds and bank FDs can both be used. But while the returns of short-term debt funds are not fixed, there is penalty for premature withdrawal from bank FDs. If you have invested in short-term bond funds, hold them for now. The Finance Bill hasn’t been passed yet. The MF industry has requested the capital market regulator to intervene. Clarifications are expected in about a week or so.