Personal Finance

A sweet, short haul with FMPs

Vidya Bala | Updated on July 29, 2011 Published on July 23, 2011

Fixed maturity plans, which are one year close-ended debt products, could result in attractive yields.

With short term interest rates of less than a year looking good, it is not only banks which are coming up with attractive one-year deposits. Mutual funds too have been launching a number of one year close-ended debt products called Fixed Maturity Plans (FMPs) that could offer attractive yields.

However, there is the catch. Despite higher risk compared with deposits, FMPs, which typically invest in debt instruments for a fixed period, be it money market instruments or government and corporate bonds, were seen a superior option to bank deposits, due to their lower tax incidence. This is set to change if the revised draft of Direct Tax Code (DTC) is to be adopted in its current form from April 2012. Here's a quick recap on what made FMPs superior to Fixed Deposits (FDs) so far and how investors have to be selective with FMPs from hereon, if they have to enjoy optimal post-tax returns.

Neither short nor long

Unlike fixed deposits of banks or corporates, which are taxed at the regular income slab of an individual, FMPs had a tax structure based on capital gains. While gains made on FMPs held for less than a year were clubbed with your income, those with tenure of over one year were subject to 20 per cent or 10 per cent tax, with or without indexation benefits respectively. This was beneficial to investors in the higher end of the tax bracket of say 20 or 30 per cent.

However, the proposed DTC is set to change this treatment. For one, the new code will not differentiate between short or long term capital gains. Both would be added to the individual's regular income and taxed along with it. This would be no different from the treatment for interest on deposits. Two, while indexation benefit for long term gains would continue for debt mutual funds, they come with strings attached.

To enjoy indexation under DTC the investment should be held for one year from the end of the financial year in which it was made. For example, if you bought a 370-day FMP today maturing in July 2012, the returns would, under the current tax regime enjoy indexation benefit as they would be treated as long term gains. However, under DTC, the one-year period would kick start only from the end of the financial year – which is March 2012. So a fund which is held up to April 2013 would only enjoy the ‘long term' status.

To make a long story short FMPs invested now for one-year tenure, would suffer the same tax as fixed deposits.

And as things stand today FMP yields may at best match or slightly fall short of the maximum of 9.75 per cent interest rate that bank deposits provide. Thus, the post-tax yield of FMPs may not turn out to be superior.

This said FMPs still make for a good diversification option as you may not want to park all your money in deposits. And they may at times, especially in the case of long tenure funds, offer superior yields to bank deposits. Here are some ways to overcome the limitation posed by the new tax code.

How to overcome

If you indeed want to go for one-year FMP now, you could opt for the dividend payout option, especially if you are under a high tax bracket. This would help reduce the final capital gain that arises on maturity as much of it would have been paid out. No doubt, dividends suffer dividend distribution tax at the fund's end (not in your hands). But the 14.165 per cent dividend tax is still lesser than the higher tax you would suffer as short-term capital gains.

The proposed law for availing indexation benefit can be used to the maximum if investments are made in the month of March in any year. For instance, if you decide to invest in a 370-day FMP in March 2012, you would be able to enjoy long term indexation benefit in April 2013, when the fund matures. But do not lose sight of the likely yields that the FMP would deliver. One year returns may turn less attractive if the interest rate hikes are over.

A FMP with tenure of 20 months and above would only provide you with long term indexation benefit currently. However, such FMPs may not be easy to come by right now, as most funds are focussing on one-year tenure given the higher interest rate in short-term debt instruments. However, you can expect these instruments aplenty, once it is clear that rate hikes are over and yields start trending down.

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