Inflation index to the rescue of FMP investors

Last Updated: Mon, Apr 22, 2013 05:19 hrs

If the high inflation of recent years is benefiting anyone, it's probably those who've invested in fixed maturity plans (FMPs). Depending on when it was made, investors in FMPs maturing this month stand to gain by paying capital gains tax on lower amounts or not paying tax by showing a notional loss.

This is because of inflation indexation. Indexation increases the cost of acquisition, as it adjusts for inflation.

Every year, the government announces an inflation indexation. For 2011-12, it was 785; for 2012-13, it was 852. For 2013-14, it would be announced in September. For long-term investments---those maturing after more than a year---the tax is 20 per cent with indexation and 10 per cent without indexation. Since indexation could make your gains seem lower, you would have to pay the 20 per cent tax only on those gains. This could lead to substantial savings. In the following examples, we have assumed inflation to be six per cent in 2013-14, according to the projection in the Reserve Bank of India's previous monetary policy review.

Example 1 (Table 1)
Let's consider a fund with a tenure of 385 days. Assume the amount invested is Rs 1,00,000. The investment is made on, say, March 27, 2012, and matures on April 17, 2013. The fund matures in the third financial year from the year of investment. The net asset value (NAV) while investing is Rs 10. During maturity, the NAV is Rs 11.04, after deducting expenses. The redemption value is Rs 1,10,400. So, the gain is Rs 10,400. The absolute gain is 10.4 per cent; the annualised gain is 9.86 per cent.

In this case, the indexed cost of purchase (cost inflation in the interim period) comes to Rs 1,15,032. The inflation indexation for 2011-12 is 785; for 2012-13, it is 852; for 2013-14, it is assumed to be 903 (six per cent rise over the last financial year). So, going by the indexed cost of purchase of Rs 1,15,032, the absolute gain of Rs 1,10,400 is a loss of Rs 4,632. There is no tax to be paid on the loss.

Example 2 (Table 2)
Considering inflation indexation, the capital gains stand at Rs 4,415. The long-term capital gains tax of 20 per cent would be applicable on this amount and it comes to Rs 883. If the tax was 10 per cent tax without indexation, the amount would be Rs 1,040, taxed on the total gain of Rs 10,400.

The benchmark for an FMP with a maturity period of more than a year would be a one-year bank fixed deposit, which currently offers 8-9.5 per cent. Most FMPs with maturity periods of more than a year and maturing in April 2013 offer more than nine per cent.

Feroze Azeez, director and head (investment products), Anand Rathi Private Wealth Management, says most FMPs issued last year have delivered good returns; they haven't defaulted. One advantage is since the maturity period is more than a year, these give the benefit of double indexation and one could pay capital gains tax on lower gains. Another advantage is these could give a notional loss and be offset against gains from other investments. These could also be carried forward for eight years, according to taxation laws. But since it is a long-term loss, it could only be offset against a long-term gain

The returns from FMPs issued in 2012 are more than nine per cent, very good considering the current interest rates, says Surajit Misra, executive vice-president & national head (mutual funds) at Bajaj Capital. Most have outperformed certificates of deposit issued by banks. "If you have invested before March 31, 2012, and it is maturing after April 2013, you would get the benefit of double indexation. And, since the inflation index was high last year, the returns are tax-free," he says.

But for this year, investors would be better off investing in open-ended short-term and long-term accrual funds, since interest rates are likely to decline from current levels, he adds.

Sujoy Das, head (fixed income), Religare Asset Management, says FMPs are a good option for those averse to interest rate risks. "Irrespective of what happens to the interest rate cycle, the investor would get the money back on a particular date," he says.

Earlier, fund houses were allowed to indicate a certain yield on FMPs. But now, they cannot do so. However, the returns are more or less stable and predictable, because the investments are in instruments or papers of the same maturity as the FMP, and these are held till maturity, says Dhruva Chatterjee, senior research analyst, Morningstar India.

"Because of the high interest rate environment last year, quite a few FMPs were launched. This year, there have been some, though not as many as last year. Though the yields on the benchmark securities are lower this year compared to last year, investors prefer to lock into a yield," says Chatterjee.

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