Fixed Maturity Plan and the Direct Taxes Code (DTC) Effect

Fixed maturity plans (FMPs) have been very popular with investors because they are more tax efficient than FD’s.
If the FMP term exceeds one year , the income is treated as long term capital gains and taxed at flat 10% or 20% after indexation. In case of fixed deposits , the interest earned is clubbed with the income of investor and taxed at the normal rate. That is why a 370 day FMP is the most common maturity in this category.

But this is set to change if Direct Taxes Code (DTC) replaces the Income Tax Act from April 1 , 2012. FMPs will lose some of the tax advantage they enjoy under the current tax regime.The DTC will not make a distinction between long-term and short term capital gains form debt mutual funds. All gains will be added to income of investor and taxed at normal rate applicable to him.This means if you buy a 370 day FMP today , the gains will be taxed at same rate as the interest earned on Fixed deposit. So if you want to invest for a period of one year right now , a fixed deposit might be a better bet , given the post tax returns will more or less the same.

There’s another way in which the DTC queers the pitch for FMPs. As mentioned earlier , long term capital gains from debt funds are taxed at flat 10% or 20% with indexation. Indexation takes into account the inflation during the holding period while calculating the cost of acquisition of an asset. For instance , if an asset was bought in March 2010 (financial year 2009-10) and sold in April 2011 (financial year 2011-12) , it would be eligible for inflation adjustment for two years. This will change under DTC. For an investment to quality for long-term capital gains, the asset has to be held for at least one year from the end of financial year in which it was bought. So in you invest in FMP right now , one year period will start from April 1 , 2012 and term should extend till March 31 , 2013 for the income to be treated as long term capital gains.
Indexation benefits will be available only if gains are long term.Obviously a 370 day FMP won’t make the cut if you buy right now.But it will do so if it is bought in the last week of financial year.If you buy in March 2012 , the FMP matures in April 2013 , the gains will be long term capital gains. Given this new rule for calculating the holding period , an investment will have to be held for terms varying from between a little over a year to up to two years to quality fo long term capital gains treatment.If you want to invest now and are looking for indexation benefits , going for a 735 day plan can be an option. A 1,100 day plan will fetch you double indexation.Though such long maturities are rare right now , mutual funds are likely to launch more such plans once the DTC proposals become a law.There’s another change in indexation rules.Under DTC , long term capital gains after indexation will be taxed at the marginal rate of tax.So if you fall in 30% tax bracket , the long term capital gains after indexation will be taxed at peak rate.

So in brief things to keep in mind:

- Under DTC , there will be no difference on long term and short term capital gains from debt funds.Gains will be added to income and taxed at normal rate.

- To qualify for long term capital gains , the asset will have to be held for at least one year from the end of financial year in which it was bought.

-If you invest in a 370 day FMP right now , it won’t get benefit of indexation.But it will do so if it is bought in the last week of the financial year.
-Long term capital gains after indexation will be taxed at the marginal rate.The tax will be 30% in the highest tax bracket.