Taxing Fixed Income

Fixed income securities are an important part of any portfolio. These securities represent investments that provide income in the form of fixed periodic payments and the repayment of principal amount at the time of maturity. For example, when you buy a security, you are lending money for a specified period of time. In return, you get periodic payments, as well as the principal amount, at the end of the specified period.

One of the important criterion for selection of fixed income securities is risk. Prudence demands evaluation of returns to be weighed against not only risk but also incidental costs, which gives the ‘real’ return on investment.

Tax is one of the most dynamic cost factors impacting decision making on investments. With the advent of the proposed Direct Taxes Code (DTC) likely to be effective from 1 April 2012, tax will play an important role in designing an investment basket.

The DTC proposes to restrict the deduction of Rs 1 lakh (currently available for a host of investments) only to approved provident fund and pension scheme investments. An additional deduction of Rs 50,000 has been proposed for health insurance, life insurance and for tuition fee. Under the proposed DTC, the government has taken a clear stand to encourage only certain long-term investments. These investments are not taxable when investing, annual accretion or on withdrawal proceeds subject to specified conditions.

Some fixed income securities and its taxability under the Indian tax laws and the proposed DTC are given below:

FIXED DEPOSITS (FD)

FDs may be corporate FDs or bank FDs. Between the two, bank deposits are preferred—due to their relative low risk—over company deposits, which offer higher returns but carry higher risk. Under the limit of Rs 1 lakh, investment in bank FDs for a specified period of time is eligible for a deduction. Interest received from FDs is taxable as income from other sources and the tax rate depends on the tax slabs applicable to the individual (10%, 20% or 30% as per the law).

Under the DTC, the above deduction has been recommended to be withdrawn. Hence, investments in specified bank deposits will no longer yield any tax savings.

FIXED MATURITY PLAN (FMP)

FMPs are closed-ended mutual fund schemes that generally invest in debt instruments. Their maturity period is pre-defined and are generally listed so that investors can sell their units at the exchange. With respect to taxability of the returns, if investors opt for the dividend option, the dividend is tax free. If investors opt for the growth option, they are subject to capital gains tax. For example, if the maturity period of an FMP is more than a year, one may opt for taxation at 10% without indexation or 20% with indexation. Under the DTC, all capital gains will be taxed at normal rates except sale of listed equity shares or units of equity-oriented funds. Indexation benefit will be available if the FMPs are transferred after one year from the end of the financial year in which the assets are purchased.

PUBLIC PROVIDENT FUND (PPF)

The PPF is one of the most lucrative long-term small saving schemes. A PPF account can be opened with nationalised banks or post offices. Subscriptions to PPF cannot be less than Rs 500 annually. Investments up to Rs 70,000 (to increase to Rs 1 lakh) in a year, are eligible for deduction. Under the existing tax laws, the entire amount, including the interest, is tax exempt on maturity and remains unchanged under the DTC.

NATIONAL SAVING CERTIFICATES (NSC)

NSC is an instrument facilitating long-term savings. It is ideal for those who are looking at tax benefits over a long-term and have not exhausted the limit of Rs 1 lakh. The minimum amount of investment can be Rs 100 and there is no maximum limit. Under the limit of Rs 1 lakh, a deduction is allowed for making investments in NSCs and the annual interest is accrued thereon. Interest earned on NSC is added as income from other sources and claimed as deduction. It has been recommended to withdraw the deduction benefit under the DTC.

FIXED RETURN RETAIL BONDS

A new fixed return product gaining popularity is fixed return retail bonds. It earns a fixed rate of interest and are generally listed on stock exchanges, providing an option to exit before the maturity date.

Under existing tax laws, interest earned on these bonds is taxable as income from other sources. There are no tax benefits for investing in these. When you sell, a capital gains tax is levied based on the holding period. Under the DTC, capital gains will be taxed at normal rates. More clarity on capital gains will unfold once the proposed DTC is effective.

In the existing tax scenario, the net tax cost at the time of investment may make certain investments comparatively lucrative. However, the tax impact on the returns at the time of accretion, redemption or maturity also needs to be considered. This analysis may need a complete revisit once the finalised DTC is notified and effective.