Will FMPs lose their lustre after debt fund taxation changes?

Among other things, this was likely to impact the post-tax returns of predominantly debt funds. One of the only closed-ended debt fund categories are the Fixed Maturity Plans (FMPs) and double taxation was one of the major attractions of FMPs. Now that is likely to go away. But first, here is a look at the top FMPs in India on 1-year returns. Only FMPs with AUM above Rs100 crore are considered.

Data Source: AMFI

Normally, the maximum tenure of an FMP is around 3-5 years, so 3 year returns or 5 year returns are not too different from 1 year returns. But before we go ahead, here is a look at what the recent amendment to debt fund taxation in the Finance Bill really was.

Finance Bill 2023-24 announces changes to debt fund taxation

Currently, any mutual fund with an exposure of 65% or more to equity is classified as equity fund and the rest are classified as non-equity funds (debt funds). Today, capital gains on debt funds (non-equity funds) are taxed at 2 levels. 

• If debt  funds held for less than 36 months, it is short term capital gains and is taxed at the incremental rate of tax applicable, depending on the tax bracket of the investor.

   

• If debt fund is held for more than 36 months, it is LTCG and taxed at concessional 20% rate with indexation benefit. Normally, effective tax is less than 10% in most cases. 

The Finance Bill 2023-24 has effectively broken up non-equity (debt) funds into 2 sub-categories to be taxed differently. Here are the details.

• Debt funds holding less than 65% in equity but more than 35% in equity, will continue to get the same tax treatment. STCG will be taxed at peak rates but LTCG will be taxed at 20% with indexation benefits.

   

• If the equity component is less than 35% of the portfolio, then any gains (irrespective of holding period), will be treated as other income and taxed at the peak rate applicable. The predominantly debt funds will be effectively at par with bank FDs and debentures.

This is likely to have a negative impact on the FMPs as these FMPs are predominantly debt funds with very small equity component and bond maturities matching the tenure. These FMPs will lose their double indexation benefit and could lose their attractiveness.

Loss of double indexation benefit will hit FMPs

One of the biggest attractions of fixed maturity plans (FMPs) is the tax efficiency. This tax efficiency is due to the double indexation benefit that is leveraged by most of the AMCs. Let us first understand how this double indexation benefit actually works for FMPs. Typically, the FMPs are closed ended funds are the NFOs come out in February and March, such that the effective allocation day for the FMP is, say, around 15th March 2019. Then the maturity date of the FMP is set at a little over 3 years such that it matures on 15th April 2022, implying holding period of 1,126 days. Now the tenure of this FMP is a just a little more than 3 years. However, between issue and maturity, the FMP straddles 4 fiscal years i.e., FY19 to FY23. That gives the double indexation benefit. 

Here is how the double indexation benefit works for an FMP. But before that, let us look at the index numbers i.e., FY19 (280), FY20(289), FY21 (301), FY22 (317) and FY23 (331). The calculations of double indexation benefit are illustrated in the table below.

In the above case, let us assume that the starting NAV was Rs100 while the redemption NAV at the end of 1,126 days is Rs121.4428. That translates into an annual CAGR return on the FMP of 6.50% approximately.

What do we gather from the above table. On a total capital gain of Rs21.4428, the investor will pay total capital gains tax of Rs0.6457. That translates into an effective tax rate on capital gains of just 3.01%. Remember that the indexation benefit is anyways available for 3 years. But by tweaking the launch and redemption dates, there is double indexation benefit. That reduces the tax to just about 3.01% effective rate.

This is the benefit that fixed maturity plans (FMPs) will lose out from April 2023 onwards. Going ahead, FMPs will end up paying tax at peak rate on the entire capital gains earned. That is likely to make them less attractive to conservative investors and reduce the appetite for FMPs among issuers and investors.