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Taxpayers in Top Brackets can enjoy Totally Tax-free Returns availing Multiple Indexation!

              Arjun had invested Rs.25,00,000 in March, 2010 in a 13 months Fixed Maturity Plan (FMP) offered by a leading Mutual Fund. The indicative return offered to him was 11% upon maturity of the FMP in April, 2011.  Arjun will be fortunate to earn Rs.2,75,000 as his return on investment totally tax free. How does this work?
              Arjun’s return on FMP investment over the holding period of more than 12 months qualifies as Long term Capital Gains (LTCG) and is entitled to enjoy the double indexation benefit. The Cost Inflation Index (CII) for FY 2009-10 was 632 and for FY 2011-12 is 785. On the basis of the same, against his cost of Rs.25,00,000 in 2009-10, the indexed cost would work out to Rs.31,05,222. Keeping in view the maturity consideration of Rs.27,75,000 received by Arjun, he would be in a position to show a notional loss of Rs.3,30,222. Thus on his return of Rs.2,75,000, the liability to income tax will be effectively zero.  


             FMPs are investment schemes floated by mutual funds and are close-ended with a maturity period ranging from three months to five years. The objective is to lock into a certain rate of return on risk-free or highly-rated assets at inception, thereby protecting the schemes against market fluctuations. FMPs invest in Commercial Paper, Certificate of Deposits, Debentures, Bonds, Securitized debt, Money Market instruments and the like.

             Since SEBI did not permit offering of any ‘guaranteed returns,’ FMPs earlier used to show ‘indicative returns.’ However, as per its latest directive in 2011, SEBI now does not permit a Mutual Fund offer document to even show any indicative FMP returns. This means the investor would be required to do the research on current commercial ongoing rates of the same maturity as of the FMP and guess approximate returns, assuming that the particular fixed maturity fund invests in quality commercial deposits and Government securities.

             In this context, investing in a Mutual Fund FMP (where the return is based on a guess factor) is indeed a more challenging investment decision, than investing in a Bank FD which promises a guaranteed return.   


             However, investment in FMPs scores high above Bank FDs, when it comes to comparing the tax advantage.

             Investment options in FMPs are available on dividend payout basis or under the growth scheme. Dividends are exempt in the hands of the recipient, but attract Dividend Distribution Tax (DDT) of 13.52% in the case of Individuals and HUFs. If a dividend option FMP is yielding 10%, after taking into consideration the 13.52% DDT impact, the effective return would work out to 8.65%, which would still favorably compare with the post-tax return of 6.91% under a Bank FD carrying an interest rate of 10%, in the case of a high net worth Individual or HUF in the top tax bracket of 30.9%.

             It needs to be borne in mind that FMPs under the dividend option are no longer attractive for Firms and Companies, more particularly with effect from the current FY 2011-12, after the DDT rate in their cases has been hiked to 32.45% from the earlier 22.15%.    

             Under the provisions of Section 112 of the Income-tax Act, LTCG earned on FMPs under the growth option is liable to be taxed at 10.3%, without indexation, or at 20.6% after availing the benefit of indexation. Growth schemes, which enjoy the benefit of indexation (or even multiple indexation) under Capital Gains can effectively offer virtually tax-free returns, as highlighted in the illustration of Arjun discussed hereinabove.

            For this reason, top tax bracket investors prefer investment in FMPs under the growth option as compared to Bank FDs, which offer similar returns, but are liable to tax upto 30.9%. The break even rate of interest before tax in the case of a growth option FMP yielding a 10% return, thus actually compares to a 14.47% return on investment, in the case of a taxpayer in the maximum bracket of 30.9%.


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