India is a country where inherently everyone’s mind is set to strategically save their surplus amount of income, to stand against any future unusuality and better life in the future. In ancient India, most of the Indian people used to save and invest their money in the form of gold and silver bullion, utensils, jewellery, etc. Thereafter due to India’s modernisation and Remarkable growth and expansion of the banking sector in urban as well as rural areas, people were encouraged to secure their money in the hands of banks by way of fixed deposits (FD) and saving deposits.
According to the latest Reserve Bank of India (RBI) report, Fixed Deposits (FDs) emerge as the predominant investment method, constituting 35% of India’s total savings. followed by saving accounts holding 31%.
The interest yield on FDs is contingent upon both the duration and volume of the deposits. On average, an individual intending to invest ₹10 lakh in FD for 3 years, can potentially earn an annual interest ranging between 7% and 8%.
On the contrary, money itself does not retain its purchasing power unaffected due to inflation within the economy. Inflation diminishes the rupee’s ability to acquire the same quantity of a commodity as it could acquire a year prior.”
The inflation rate in India for the year 2022 stood at 6.67%. This implies that if an item was purchasable at the price of ₹1,000 in 2022, one would be required to spend ₹1,066.7 to acquire the same quantity of the item today.
Investing in fixed deposits is one of the most practiced investment option by Indian people as the interest on FDs frequently surpasses the average inflation rates. this allows the amount so invested to retain its market value upon the time of maturity of the deposit.
While FDs are widely regarded as a secure means to preserve the value of savings, it’s important to recognize that they do not enhance the value of the investment, it only maintains its value in accordance with the inflation and market trends.
The real problem that has caught my attention now comes
Individuals who believe that FD sustains the value of saving often neglect the income tax obligation on interest income generated from such investment
Due to the payment of considerable income tax, the actual effective interest rate significantly reduces, occasionally falling below the average inflation rate.
For instance,
Let’s consider the case of Mr. A whose annual income is ₹7,00,000 has invested ₹15,00,000 in a Fixed Deposit at an interest rate of 7%. his annual interest return will be ₹1,05,000.
Not getting into the deep calculation, as his income other than FD interest is more than 5 lakhs and below 10 lakhs, the Income Tax liability on such interest income will be 20.8% (20% income tax + 4% CESS) amounting to ₹21,840
As a result of this taxation, the effective net-of-tax interest yield will be
(1,05,000-21,840)/15,00,000 = 5.544%
This indicates that although the interest earned on FD may exceed the average inflation rate, the post-tax interest ultimately yields a return that is much lower than the inflation rate.
If Mr. A’s income exceeds ₹10,00,000 this interest income will be subject to tax @31.2% (30% + 4% CESS)
Resulting in the reduced Return on Investment (ROI) of
(1,05,000 – 31.2%)/15,00,000 = 4.816%
As the FD generates a return lower than the inflation rate money being physically secured in FD loses its financial value i.e. purchasing power
here, tax implication on such interest should be charged after considering the inflation.
The investment intended primarily to preserve the value of savings should be subject to taxation on the surplus ROI derived from the investment. This surplus can be seen as representing the market risk premium associated with the investment.
In the given example
Mr. A is only gaining (7% – 6.67%) = 0.33% as the market risk premium, totaling
₹15,00,000 * 0.33% = ₹4,950.
This amount represents the actual return realized by Mr. A after considering the impact of inflation. The tax implication should be based on this actual return amount.
As in the computation of long-term capital gains as per the 2nd proviso to section 48 of Income Tax Act 1961, the consideration of inflation is evident through the Cost Inflation Index (CII), which adjusts the cost of the capital asset. Similar logic with different treatment should be extended to Fixed Deposit’s interest income, which will prevent the unnoticed and uncalculated loss of money’s indirect value faced by numerous individuals of India unaware of this aspect.
Author: Hitsar Raveendra Shah | CA Final Student | (AIR 29) CA Inter Nov 22
Author Bio
Well said, but real inflation is not 6.7% but nearly 15%.
That is why people indulge in cash transaction and avoid paying taxes
Sensible article, but then FDR investors are low hanging fruits for Govt.