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FMPs and how to save tax

By Anubhav Arora and Vivek Kaul
April 29, 2005 14:00 IST
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After the tax restructuring exercise carried out by Finance Minister P Chidambaram in the Budget, investors are looking for options that are more lucrative in terms of tax-adjusted returns.

With the abolishment of Section 80L (of the Income Tax Act), the income from bank deposits has become completely taxable. Thus, investors who saved taxes through these deposits would now have to look for other options.

Bank deposits cater to that segment of investors that looks for safety and accepts a relatively low return. For them most of the equity mutual fund schemes may not be very attractive. This is because of the inherent risk of losing a part of capital in such schemes even though these schemes can give high returns.

A Fixed Maturity Plan (FMP) is a good option to cater to the requirements of such investors.

This article attempts to explain FMPs as a mode of investment.

The concept

An FMP is a type of a mutual fund that invests in financial instruments whose maturity date coincides with a specific time period indicated in advance by the fund, and hence the name 'Fixed Maturity Plan.'

The instruments that constitute the assets of an FMP mature on the same date the plan is due for maturity. For example: An FMP of 1-year duration will invest in instruments that mature in one year.

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FMPs 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). The instruments are held till maturity and give less volatile returns to the investor in comparison to equity funds.

These plans suit investors who have a time horizon of 15 days, 1 month, 3 months, 6 months and 1 year. Few schemes are also available with a maturity of 3 years and 5 years.

FMPs are offered by a plethora of mutual funds like HDFC Mutual Fund, Prudential ICICI Mutual Fund, Kotak Mahindra Mutual Fund, Birla Mutual Fund, ING Vysya Mutual Fund, etc.

They are similar to the close-ended mutual fund schemes, which make a one-time sale of a fixed number of units to investors during the initial public offering (IPO) period. However, unlike close-ended funds, FMPs equip the investors with the option to exit.

The exit is subjected to an exit load (as per the regulations of the fund), which is deducted from the redemption proceeds payable to the investor. However, the withdrawal options vary from scheme to scheme and the investor should validate these options from the offer document or the key information memorandum (an abridged version of the offer document) of the fund.

The benefits

The degree of risk of a mutual fund depends on the kind of assets it invests in (which in turn depends on the investment objective of the fund). Equity funds have a greater risk of capital loss than debt funds or money market funds, primarily because the stock prices fluctuate and companies may or may not give dividends during a particular time period.

FMPs are also less risky than equity funds because of the kind assets they invest in. FMPs help in the mitigation of interest rate risk, credit risk and liquidity risk.

Interest rate risk is a risk due to variation in price of a bond in a direction opposite to the movement in the interest rate. When interest rates rise, bond prices fall, which leads to a loss for the existing bond portfolio. FMPs are free from interest rate risk as they invest in instruments held till maturity, thereby ensuring a fixed rate of return.

But this benefit comes with an opportunity cost. Since FMPs hold securities till maturity they cannot book profits when interest rates fall.

Credit risk is the risk of default of the issuer on its obligations to make timely principal and interest repayments. This risk is mitigated by FMPs as they invest in instruments having a good rating.

The element of liquidity is very critical for a fund as its investments are made on the behalf of unit-holders and it may be necessary to liquidate a part of the investment due to market conditions.

An instrument, in which liquidation of investments is difficult is said to have liquidity risk. FMPs are least affected by this risk. The applicability of an exit load thwarts withdrawals before the maturity date. Thus the fund need not liquidate its investments before maturity.

The predictability of returns that FMPs offer also makes them more attractive. The instruments an FMP invests in are held for redemption on the day of maturity of the plan. Thus funds can manage to get a specific interest on these instruments and investors have an idea about it. This helps investors tailor their investments as per their future cash requirements.

FMPs involve minimum expenditure, as there is no requirement for a time-to-time review by fund managers to buy/sell the instruments constituting the fund. Since these instruments are held till maturity, there is a cost saving in respect of buying and selling of instruments.

Further, with the help of FMPs investors can get 'Double Indexation' benefit, which is not available in case of fixed deposits and bonds. This advantage can be taken by investing in an FMP just prior to the end of a financial year and withdrawing it after the end of next financial year, that is, an investor can invest in an FMP on March 31 in one year and withdraw it on April 1, the next year.

Thus, the amount remains invested for a period slightly greater than a year. This ensures the applicability of indexation benefits for inflationary changes in two years, which can help investors, reduce the tax.

Double indexation, in some cases, can even lead to a net loss figure, even though there is a profit, and thus expunges the tax obligation of the investors.

The taxable amount is calculated using the following formula:

Taxable Gains = Amount Returned – (Amount Invested * Inflation Index for Redemption Year/ Inflation Index for Investment Year)

The following example explains this concept:

Suppose a plan returns 4% on an amount of Rs 10,000, invested for a period slightly greater than a year. Thus the amount returned would be Rs 10,400. Now suppose, the inflation index calculated for the period is 1.05. This means that an amount of Rs 10,500 (10,000 multiplied by 1.05) would be used for calculating taxable gains.

Since Rs 10,400 is less than this amount, there is no gain on which tax is applicable. However, suppose the return from the fund amounts to Rs 11,000. Then, the investor has to pay taxes on a gain of Rs 500, even though the net gain was Rs 1,000.

In closing

FMPs are available with numerous maturity options – 15 days, 1 month, 3 months, 6 months, 1 year, 3 years and 5 years. But there is a dearth of schemes in the 3-year and 5-year range. Moreover, when investors go in for FMPs of greater than 1-year duration, an inherent risk of tax policy changes is involved.

If the finance minister remodels the tax policy to discontinue double indexation, then investors might have to pay more taxes on gains from FMPs. In this case, they won't be of help to medium-term and long-term investors.

Some of these schemes invest in a single security that matures on a particular date. Such schemes infringe the entire concept of mutual funds, where the entire risk is avoided by investing in a diverse set of securities.

These plans with their inherent tax benefits perform better than bank deposits of some of the banks. However, this may apply to the plans of maturity at least equal to a year or greater.

So far as short-term plans are concerned, bank deposits might prove out to be more remunerative at times. Thus, an in-depth analysis is required before investing in FMPs of maturity less than 1 year.

Anubhav Arora is student, ICFAI Business School, Hyderabad. Vivek Kaul is a freelance writer.

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