Fixed maturity plans (FMPs) are closed-ended investment schemes with maturity periods ranging from one month to a few years, which typically invest in lowrisk debt and money market instruments. FMPs offer investors an excellent opportunity to benefit from the current high interest rates and the lower rate of tax on their income.
As FMPs are debt funds, the longterm capital gains are taxed at 20% (with indexation) or 10% (without indexation), while short-term gains are clubbed with the investor’s income and taxed at the applicable rate. Indexation reduces the tax rate further by adjusting the gains for inflation during the investment tenure. Investing in schemes with tenures that spread over two or more financial years are especially rewarding because the investor gets the benefit of double indexation. For instance, a 16-month FMP launched on 1 February, 2008, will mature on 31 May, 2009. It will pass through three financial years and thus the investor is eligible to benefit from double cost indexation while calculating the tax on profit.
|How indexation works|
|RS 1 lakh invested on 1 Feb, 2008, Redeemed On 31 May, 2009||Growth Option||Dividend option with indexation|
|With Indexation||Without Indexation|
|DDT (12.41% of the distributable amount) [A]||NA||NA||1,365|
|Balance distributed as dividend||NA||NA||9,635|
|Long-term capital gain/(loss)||837||11,000||-10,163#|
|Income tax [B]||190||1,246||(2,302)*|
|Total taxes [A]+[B]||190||1,246||1,365|
|Post-tax return (%)||10.81||9.75||9.64|
|Indicative yield is 11%; Income tax assumed at 22.66%; Indexed cost of acquisition works out to Rs 1,10,163;|
The Cost Inflation Index for 2007-8 is 551 and is assumed to be 607 for 2009-10;
#Long-term capital loss can offset any other taxable long-term capital gain; *Tax saved from such offsetting of loss
Some FMPs also provide a dividend option. The investors can opt for the dividend to be paid out or re-invested. This is useful if the FMP is short-term and the investor is in the highest tax bracket as dividends are tax-free and the dividend distribution tax (DDT) would be far lower than the marginal tax he would have to pay on the short-term capital gain.
However, it would be useful to keep in mind the dividend stripping provisions in this context. Any loss from the sale of units purchased within three months before the record date for dividend distribution and sold within nine months after such date, is to be ignored.
The 2007 Budget levied a higher DDT on certain categories of debt funds, namely liquid funds, which predominantly invest in debt securities with residual maturity of less than one year, and money market funds, which invest exclusively in instruments such as commercial papers, certificates of deposit, treasury bills, gilts with unexpired maturity of less than a year, call money and other such notified instruments. Since the instruments in which FMPs invest are very similar to those in which liquid and cash funds invest, the question is whether FMPs also attract a higher DDT prescribed by the 2007 Budget.
Though FMPs have features similar to those of some recognised liquid plans, they do not confine their investments to debt securities of less than one year. FMPs invest in both debt and money market instruments, so they do not fulfil the exclusivity criteria for investments in money market instruments and, therefore, do not qualify as money market funds. Also, providing liquidity to investors is not the objective of an FMP. On the contrary, they discourage premature redemptions with higher exit loads.
Since FMPs do not fit squarely into the definition of liquid funds or money market funds, the DDT rate is lower.
Prakash Shah and Avan Badshaw, Senior tax professionals, Ernst & Young
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