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Direct Taxes Code (DTC) and its effect on Fixed Maturity Plans (FMPs)

As the Income Tax Act makes way with effect from April 1, 2012, for the Direct Taxes Code, investors should be careful of overlapping investments. Meaning, investments where the IT Act is applicable while making it, whereas it is the DTC that will apply at the time of maturity.

For example, take the currently popular Fixed Maturity Plans (FMPs) of mutual funds. The attraction of these schemes is the tax efficiency they offer over bank fixed deposits. Both bank FDs and FMPs offer a similar rate of return. While the interest on bank deposits is taxed at the normal rate, in the case of FMPs (over a year), the 10 per cent (20 per cent with indexation) capital gains tax rate applies. Consequently, on a post-tax basis, an FMP is much more advantageous.

However, there is a significant issue. If you were to invest in, say, any one year FMP available currently, the IT Act applies at the time of making the investment. However, at maturity (2012-13), the DTC would apply. And, under the DTC, the tax advantage an FMP has may not be available. Let's understand how and why.

Basically, long-term capital gains from equity shares and equity-oriented mutual funds continue to be tax-free under the DTC. However, the current system of long-term capital gain taxation of non-equity MFs (10 per cent without indexation or 20 per cent with indexation) has been discontinued under the DTC. Though indexation will apply, the resultant capital gain would be added to the other income of the taxpayer and be brought to tax at the slab rates applicable. (Note here that it is not indexation per se but only the special rate of 20 per cent after indexation that is discontinued – indexation itself continues to apply).

Also, under the DTC, there is a significant departure from the ITA with respect to the method of determining whether a non-equity asset is long-term or not. For instance, under the ITA, a financial asset has to be held for over a year to qualify as long-term. Such a holding period is calculated from the date of purchase to the date of sale. For example, if you invest in an FMP in, say, August 2011, it would qualify as a long-term asset with effect from August 2012. However, under the DTC, the asset has to be held for over one year from the end of the financial year in which it was acquired. So, taking the same example, the FMP will qualify as long-term under the DTC only if held for over one year. From March 31, 2012, it will be considered a long-term asset only if sold anytime from April 2013 onwards.

So, let's see what these provisions mean for a typical 370-day FMP on offer currently (say in August). First, since the maturity of this FMP will be in August 2012, it is the DTC provisions that would apply, not those of the IT Act. That being said, since an FMP is a nonequity asset, the current system of 10 per cent (20 per cent with indexation) will not apply and, instead, the income will be subjected to the marginal rate of tax. Even this one could have lived with, since at least the net income subjected to tax would be lower due to applicability of indexation. However, in the above example, for the FMP to qualify as a longterm asset (and, hence, be eligible for indexation), it needs to be held for over one year from the end of the financial year in which it is purchased. That is, it needs to be held till April 2013. However, the maturity of the FMP will be in August 2012 and, hence, indexation will also not be applicable. Consequently, the income from such an FMP will be taxable just like interest from a bank deposit is – to be added to your other income and taxed at slab rates. The net effect would be that, given a similar rate of interest, there would be no difference whatsoever in the posttax return from a bank deposit and an FMP!

SUMMARY

The DTC is just round the corner. It is time various stakeholders take cognizance of this and tweak their offers in a way that would be optimal for the consumer. For example, the FMP tenure could have been so adjusted that every investor would end up qualifying for indexation benefits. Many may have already invested, not knowing (and not being warned) that at the time of maturity, the tax efficiency one has been used to all these years will not be available.

Investors, on their part, would do well to appreciate that this dual law applicability at the time of entry and exit is there for not only mutual fund schemes but also a host of other investments such as insurance plans, bonds and even to payments that earn tax deductions such as home loan instalments and tuition fees. Therefore, before committing funds for the long term, take care that the investments are tax-efficient and in conformity with the provisions of the DTC, rather than the current IT Act.
 

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