Why you must invest in fixed maturity plans

Last time we discussed how fixed maturity plans enable an investor to earn more or less an assured return in a specified timeframe. FMPs are a great alternative investment, per se as they effectively eliminate the interest rate risk by holding the underlying securities till maturity. Factor in smart investing strategies like Tax Arbitrage and Double Indexation --- and the sharp edge of this instrument becomes sharper.

This time, let's examine what these esoteric sounding strategies are.

Tax Arbitrage

The investment community at large always has had a penchant for coining complex terminology for essentially simple concepts. Tax arbitrage is a case in point.

Given a choice between paying tax at a higher rate or a lower rate on the same instrument, what would you choose? You would not even want to dignify the question by answering it, right? However, the catch here is being able to discern the fact that a particular instrument lends itself to such a choice and actually exercising it.

Lets understand this concept using an illustration. For which, we take the example of a 90 day FMP. This means that after you invest on Day 1, on the 90th day, the scheme matures and you get back your money. Consider the following table.

Granted there's a bit of number crunching but if you stay with it, its really very simple.

As corporates are up the curve on these things anyway, let's take the Individual option. At 8 per cent p.a., in 90 days (3 months), Rs. 100 will grow to Rs. 101.92. Now, if you had sold the investment at this point in time, since it is a short-term capital gain, you would have to pay tax on Rs 1.92 @33.66 per cent. However, if the same Rs 1.92 is given by the fund as dividend, the distribution tax rate will apply which is much lower at 14.025 per cent. Obviously you would choose to bear tax of 14.025 per cent rather than 33.66 per cent right?

This is nothing but Tax Arbitrage.

Before discussing Double Indexation, it is necessary to understand the concept of indexation itself. For calculating capital gains, we reduce the cost from the sale value. For calculating long-term capital gains, such cost can be enhanced by the inflation multiple.

For this purpose, CBDT releases the index figures for each financial year. Such declared index is applicable for any transaction done during the entire year. The base year is 1981-82 for which the index is 100. Then on, considering the inflation figure for the year, CBDT has been releasing indices for each year. Such an index is known as the Cost Inflation Index (CII). The CII for FY 05-06 is 497. Let's examine a simple example to illustrate the use of the CII.

Therefore, instead of paying tax on Rs. 3,00,000 just on account of the indexation benefit, you get the option of paying tax on Rs. 2,77,629.

Now, how do we use this principle in the case of FMPs? Like mentioned last time, FMPs are nothing but non-equity funds. Long-term capital gains on non-equity funds are taxed at the lower of 10 per cent without cost indexation or 20 per cent with cost indexation (as detailed above).

Double indexation is a neat trick where you hold an investment for a little more than one year but get the benefit of the index multiple of two years. How is this done? Consider the table for the 370 day FMP.

The FMP is for 370 days, exactly 5 days more than one year. However, check out the date of investment and date of exit. The entry date is 29th of March, 2006 i..e FY 05-06. The date of sale is 3rd of April, 2007 i.e. FY 07-08.

By holding the investment a little into the next financial year, an investor can use the facility of the CII for two years. The rest of the table is self-explanatory. The CII usage boosts the cost beyond the sale price due to which the investor suffers a notional capital loss.

Consequently, the entire maturity value is rendered tax-free. The net annualized return remains at 8 per cent without any tax incidence whatsoever. Double Indexation, ladies and gentlemen!

To Sum

Well, after all this analysis, at the end of the day, is the FMP product meant for you?

That would depend upon your take on the market. With stocks extremely volatile, perhaps you would like to stay out of the market and remain liquid.

However, at the same time, you may not want to lock-in your funds for any length of time. Who knows, a buying opportunity may be just around the corner --- at which time you will need ready liquidity.

Or perhaps, you are a risk averse investor who would never play the stock market but nonetheless expect a reasonable return from your fixed income investment. Or perhaps, you have some money in hand that is required at a later stage but are looking to temporarily park it somewhere safe and gainful.

The point I am trying to make is no matter what the situation, a product like the FMP always comes in handy. Of course provided you know about it!

The author is the Director of A N Shanbhag NR Group, a Mumbai based tax and investment advisory firm. He may be reached at sandeep.shanbhag@moneycontrol.com