Should you put your money in FMPs maturing after March 31, 2012?

Fixed maturity plans (FMPs) are the flavour of the season. A large number of FMPs being launched these days will mature after April 1, 2012. As per the current plans, the Direct Taxes Code (DTC) is likely to replace the Income Tax Act, 1961, as on April 1, 2012. 

There are some subtle changes in the DTC which will make FMPs a tad unattractive to invest in. But nevertheless even with these changes they will continue to be a better investment bet than fixed deposits (FDs), their nearest competitor, at least for those falling in the top tax brackets.

So how do FMPs work currently?
A lot of FMPs being launched between now and the end of the financial year (i.e. March 31, 2011) essentially work on the premise of “double indexation” benefit that is available.

Indexation takes inflation into account while calculating the cost of acquisition of an asset. Double indexation provides inflation benefits for two years, while calculating the cost of an asset, when the investor primarily holds the investment for a little over one year.

Let us try and understand this mumbo jumbo through an example of an investor who invests Rs1 lakh in an FMP maturing in 15 months from now around April 5, 2012. At a return of around 8.75% per year, at maturity the investor gets around Rs1.11 lakh or Rs110, 938 to be precise.

How to calculate capital gains currently?
In a normal scenario, the capital gains made on an investment can be calculated in a straight forward manner of subtracting the cost of acquisition from the amount received at maturity (i.e. Rs110, 938 - Rs100,000).

But in case of FMPs (as well as all other forms of debt mutual funds), the tax laws allow inflation to be taken into account while calculating the cost of acquisition of the mutual fund.

The inflation can be calculated by using cost inflation index (CII) put out by the government every year.

The CII for the current financial year (i.e. FY 2010-2011) is 711. The CII for the coming financial years are currently unavailable and have been calculated by assuming an inflation of 6% per year. Using this assumption the CII for FY 2012-13 is calculated at 799.

The indexation factor is calculated by dividing the CII in the year of maturity (799 in FY 2012-2013) with the CII in the year of purchase of the FMP (711 in FY 2010-2011).

This means 799/711 or 1.12377, which is the indexation factor. This indexation factor multiplied by Rs1 lakh, the cost of acquisition, gives us the indexed cost of acquisition, which is Rs112,377.

The capital gains/losses are essentially the difference between the amount at maturity (i.e. Rs110,938) and the indexed cost of acquisition (Rs112,377).  
After adjusting for inflation the cost of acquisition comes to Rs112,377, which is more than the amount received at maturity. Hence, the investor makes a “notional loss” of Rs1,440, which can be adjusted against any other taxable long-term capital gains.

This is a triple gain for the investor. One, he gets inflation benefits for two years, even though he holds an investment only for 15 months. Two, he does not have to pay any tax on the gains. And three, he can even adjust the capital loss against any other taxable long-term capital gains.

What DTC proposes?
In the example taken above the FMP matures on April 5, 2012. As per the current plan the DTC would by then have replaced the Income Tax Act. This changes things around a little.

In the example taken above, we had calculated the indexation factor by dividing the CII in the year of maturity of the FMP in the numerator with the CII in the year of purchase of the FMP in the denominator.
The DTC proposes to replace the denominator with the CII in the financial year following the year of the purchase of the FMP. Hence, the indexation factor is calculated by dividing the CII for the year of maturity (i.e. FY 2012-2013) with the CII for the financial year following the year of purchase of the FMP (i.e. FY 2011-2012).

So essentially what is a double indexation now, will turn into single indexation if DTC comes into force, with inflation benefits of only one year being taken into account. 

Let us try and understand this through the same example. The CII for the financial year following the year of purchase of the FMP (i.e. FY 2011-2012) is calculated at 754, by assuming a rate of inflation of 6%.
The indexation factor comes to 1.05969. This indexation factor multiplied by
Rs1 lakh gives us the indexed cost of acquisition or Rs105,969. This implies a capital gain of Rs4,969 (Rs110,938 - Rs105,969). This is taxed at the rate of 20.6%, which is the rate at which long-term capital gains after indexation are taxed, leading to a tax of Rs1,023.6.
This pulls down the real rate of return to around 7.9% per year. So that’s how things will work out in the DTC regime. As we saw earlier under the current Income Tax Act the investor will not have to pay any tax.

How does the investment compare with respect to an FD?
Instead of investing in an FMP you could invest in a 555 day FD which is on offer. The interest paid is 9%. The real return on the investment is at 6.22% if you fall in the top tax bracket of 30.9%. Given this, investing in an FMP still makes more sense than investing in an FD, for
those who fall in the top tax brackets.

The writer works in the financial services industry and can be reached at chandniburman@yahoo.com. The views expressed are personal.