Indexation is a process by which the cost of acquisition of an asset can be indexed (adjusted or inflated) over a period of time in order to bring it to current prices after taking inflation into consideration.
(Inflation in simple terms is the general rise in prices, cost of living, cost of goods and services and decrease in currency value or purchasing power of money)
Indexation is done through a mechanism using a Price Index which is adjusted for inflation. The Price Index adjusts for inflation at the time of purchase of an asset as well as at the time of its sale.
It is a well-known fact that inflation erodes an asset’s value over a period of time.
Indexation gives the investor an option to inflate (increase) the price of purchase of the asset. This helps in lowering the adverse cost impact due to inflation.
Mutual fund investments generate Capital gains (Capital gain is a gain or profit realized by way of selling a property or other such asset/investment). These gains can either be Short Term or Long Term in nature, depending on the period for which these assets are held.
The taxation aspect is different for different types of mutual funds.
However, indexation benefit is available only for capital gains realized in Debt mutual funds.
A holding period of 36 months or more is considered as long term for Debt Funds. (For Equity mutual funds, long term means a holding period of 12 months or more)
Any holding period which is less than 36 months for Debt funds is treated as short term and the gains are added to the income of investor for tax calculation.
Since indexation is used for arriving at an adjusted price of purchase after considering inflation, a Cost of Inflation Index (CII) is used for indexing (adjusting) the purchase price.
This Cost of Inflation Index number is notified by the Finance Ministry for every Financial Year and is available on the Income Tax Website
For arriving at the adjusted cost of acquisition of the Debt Fund units, we divide the Cost Inflation Index of the year in which the units are sold by the Cost Inflation Index of the Year in which these units were acquired and then multiply the figure by the actual cost at which the units were purchased.
This will give the adjusted price which can be used for calculating the Long Term Capital Gains.
For Example – Mr. A purchased 5000 units of Debt mutual fund XYZ at Rs18 in the Financial Year 2012-13 and then sold these at Rs 27 in the Financial Year 2018-19. (As the units were held for more than 36 months, this transaction qualifies for indexation benefit)
The profit realized in the transaction is: 5000 (27-18) = Rs 45000
First, we arrive at the Inflation adjusted purchase price:
Inflation-adjusted Purchase price: ( 280 /200)*18 =25.2
Then we calculate the LTCG for the transaction:
5000 x (INR 27- INR 25.2) = INR 9000
(Here Cost Inflation Index number for 2018-19 is 280 and that for 2012-13 is 200. The numbers have been taken from the Income Tax Site)
The cost of inflation index is a method through which we can calculate long-term capital gains from the sale of the assets. The inflation rate that is used in indexation is taken from the cost inflation index (CII) of the government. The value in the index is identified by the Central Government every year and is updated on the website of the Income Tax Department.
The tax rate for LTCG on Debt Funds is 20%. (Overall it will be 22.88% after including a surcharge of 10% and education cess of 4%)
This is much better than the tax levied for other Fixed Income instruments like bank Fixed Deposits.
Applicable Tax: 22.88% of INR 9000= INR 2059 as against INR 10296 (22.88% of INR 45000)
(Thus a substantial saving of INR 8237 {INR 10296- INR 2059})
The concept of Indexation makes investment in Debt mutual funds a lucrative proposition as it provides investors with an opportunity to earn reasonably better post-tax returns.
This is because indexation helps in significantly reducing the capital gains by way of using the Cost of Inflation Index.
Higher inflation rate increases the cost of acquisition (purchase price) of units which results in a decrease in profit and hence lesser capital gains. This in turn lowers the tax burden.
A portfolio must have Debt funds owing to multiple benefits like yielding predictive returns, bringing stability and providing easy liquidity.
Indexation benefit is the cherry on this benefits cake of Debt Fund investing.
Happy Investing!