Get double indexation advantage

With FMPs, you can earn a tax-free return of 8.6% annually

If I were to tell you that it is possible to earn a guaranteed tax free return of around 8.6% even in this day and age, you would think I am joking. You would tell me, “But, my bank offers me only 8.5% interest on its fixed deposit— and that too is taxed at 30%.”

But, I insist that you can earn a tax-free guaranteed return of 8.6%, perfectly legally, using the 15-month fixed-maturity plans (FMPs) offered by mutual funds (MFs).

What exactly is an FMP?
FMPs are closed-ended schemes, which seek to offer debt-like returns to the investor. FMPs open for very short durations (one to three days). They have defined life spans and are wound up after that. Hence, a 15-month FMP means all its investment will be sold after 15 months and returned to the investor.

FMPs typically invest primarily invest in debt instruments (like bonds issued by, both, the government and corporates) and money market instruments (like treasury bills, certificates of deposit and commercial papers). Hence, they try to earn (relatively) risk-free returns. Typically, the FMP manager will invest all the money as soon as he gets it.

FMPs, unlike debt funds, are free from interest rate risk. Interest rate risk is a risk leading to the variation in the price of a bond, in a direction opposite to the movement in the interest rate. Hence,  when interest rates rise, bond prices fall, which leads to a loss for the existing bond portfolio.

A fall in value of the bond portfolio that the debt fund holds, leads to the net asset value of a single unit of a debt fund also coming down. FMPs are free from interest rate risk as they invest in instruments and hold  them till maturity, thereby ensuring a fixed- rate of return.

Assets held for longer than 12 months, enjoy indexation benefits:
The long-term capital gains in respect of units of a debt MF held for a period of more than 12 months are chargeable under section 112 of the Income Tax Act at the rate of 20% (plus surcharge). Capital gains are computed after reducing the aggregate of cost of acquisition as adjusted by the cost inflation index notified by the government.

An investor has the option to apply a concessional tax rate of 10% (plus surcharge) provided the long-term capital gains are computed on the cost of acquisition. Income tax talk, as always, sounds very complicated. Let’s try and understand this through an example.

Consider an investor who invests Rs 100 in a 15-month FMP on  January 16, 2007. Assume that the MF projects an indicative yield of 8.75% p.a.

This essentially means that the fund manager will invest in securities that lock in that rate of return at the very outset. So, on maturity, the investor should expect to get Rs 110.94 on April 15, 2008. A return of 8.75% per annum on Rs 100 works out to Rs 10.94 over 15 months [100(8.75%*15/12) = Rs 10.94)].

Since the investor would have invested for a period of more than 12 months, the gains on the investment will be taxable as long-term capital gains tax.

Note that the investment has been made in financial year 2006-07, and the maturity date of the investment is in FY2008-09, i.e. over two financial years. This is where  double indexation comes in and helps spruce up the return for the investor.

Double indexation benefit
Step 1: Assume that the inflation index in FY2006-07 is 100. Also assume that the inflation in the next two years is 5% p.a. and hence the inflation cost index will rise by 5% in both the years. The cost inflation index for 2008-09 will hence be 100x1.05x1.05 = 110.25

Step 2: Compute the adjusted cost of acquisition: The cost of acquisition is adjusted by the following formula: Actual cost of purchase x (cost inflation index in 2008-2009)/ (cost inflation index in 2006-2007). Hence, in our example, the adjusted cost of your purchase
= Rs 100 x (110.25/ 100) = Rs 110.25

Step 3: Compute the capital gains: To calculate the capital gains, we  need to subtract the money received on maturity from the adjusted cost of acquisition. In our case, the capital gains
= Rs 110.94 - Rs 110.25 = Rs 0.69.

Step 4: Calculate the tax @ 20%: Given the double indexation benefits, the tax works out to be =Rs 0.69 x 20% = Rs 0.14. Note that if the 10% tax on capital gains was applied, the tax would be Rs 1.03 (10% x Rs 10.25, the difference between the adjusted cost of acquisition and the initial investment). Hence, we choose the double indexation benefit of the 20% rate.

Step 5: Calculate the net return: Net of tax, your Rs 100 rises to Rs 110.80, i.e., Rs 110.94 - Rs 0.14, which implies a return of around 8.64% p.a. The FMP in this case is a little over 12 months, i.e., 15 months. So, even though the investor holds on to the investment for three months more than a year, he gets indexation benefit for two years.

MFs usually launch a series of FMPs before the end of the financial year. Typically these are 370-day FMPs, which would collect money on March 29, 2007 and mature on April 3, 2007. The investment would be locked in for only 370 days, but the indexation benefit would be for two years.

So what’s the catch here?
Except for the fact that unlike a bank, which “promises” or “guarantees” a fixed return, the MF is barred by Sebi to offer such a promise or a guarantee. Hence, the MFs use word of mouth and through distributors, give the investor an indicative yield.

Twin benefits
Mutual funds usually launch a series of FMPs before the fiscal-end

Typically, these are 370-day FMPs, which collect money on March 29 and mature on April 3 the following year

The investment is for just 5 days more than a year, but the indexation benefit is for two years

tilotia.akhilesh@parkfa.com