Meaning of Indexation
Indexation is an effective means of avoiding draining of the gains on savings in the form of taxation. Indexation is relevant to long-term portfolios, which include debt funds and other asset groups. Indexation assists you in adjusting the purchasing price of the portfolios to account for inflation. Through this adjustment, one is able to reduce his total tax liability. Indexation is a procedure wherein the expense of purchasing an asset can be indexed (adjusted for inflation) to more fairly represent current rates.
Indexation is conducted by a procedure that is calibrated for inflation using a price index. The Price Index accounts for inflation between the time of the asset's acquisition and at the time of its selling. Since inflation corrodes the value of an asset over a time period indexation is permitted to adjust for such corrosion.
When is Indexation Applicable in Debt Funds?
In the case of debt funds, if the units are held for more than 36 months from the date of purchase, the tax on the gains is applicable at a rate of 20% with the benefit of indexation. In case the units are sold within 36 months from the date of purchase, no indexation benefit is available and the gains are added to the investors income and taxed at the rates applicable to the individual investor.
How to calculate Indexation?
Since indexation has been used after taking into account inflation to arrive at an adjusted purchasing price, the Cost of Inflation Index (CII) is used for indexing (adjusting) the purchase price. For each financial year, this Cost of Inflation Index figure is updated by the Ministry of Finance and can be found on the Income Tax Website.
Cost Inflation Index - Data as per Income Tax’s official website
The Cost Inflation Index of the year is divided in the year in which the units are sold by the Cost Inflation Index of the year in which those units were purchased and then multiply the value by the total cost at which the units were purchased in order to arrive at the adjusted cost of purchase of the units of the Debt Fund. This will provide the adjusted price that will be used for the long-term capital gains estimate.
To calculate the actual value of profit received by an investor, the following formula is used:
Actual profit (after indexation) = Sale price - purchase price * (CII of the year of selling / CII of the year of purchasing)
For example, In the 2014-15 financial year, Mr X bought 5000 units of Debt mutual fund ABC at Rs18 and then sold them at Rs 27 in the 2020-21 financial year. (This sale accounts for an indexation gain since the units were kept for more than 36 months). The inflation rate that can be used for indexation can be derived from the Cost Inflation Index (CII) of the government. The values in the index are calculated by the central government and are updated on the website of the income tax department. From 1981 on, everyone can track the Cost Inflation Index. The index value in 2014-15 was 200, while in 2020-21 this had increased to 280.
The actual the gain realized in the transaction is: 5000 units * (Rs. 27 - Rs. 18) = Rs 45000
Inflation-adjusted purchase price: (280/200)*18 = 25.20. Therefore, the inflation-adjusted purchase price is Rs. 25.20.
Hence, for this particular transaction, the LTCG for calculation of tax is 5000 units x (Rs. 27- Rs. 25.2) = INR 9000. The tax payable on this transaction will be 20% x Rs. 9,000 = Rs. 1,800.
Benefits of Indexation
Indexation has been used to adjust an investment's purchase price to show the impact of inflation on it. A higher acquisition price indicates lower income, which simply indicates a lower tax. You will be able to lower your long-term capital gains with the help of indexation, which takes down your taxable income. Indexation is one of the major factors why, when compared to traditional fixed deposits (FDs), debt funds are deemed an amazing fixed-income investment choice.
The inflation rate that can be used for indexation can be derived from the Cost Inflation Index (CII) of the government. The values in the index are calculated by the central government and are updated on the website of the income tax department. From 1981 on, everyone can track the Cost Inflation Index.
Frequently Asked Questions
1. What is Indexation?
Indexation is a method of adjusting the purchase price of an investment for inflation. This helps bring down the effect of capital gains while calculating taxable income.
2. Is indexation benefit applicable in a mutual fund investment?
Yes, indexation gives benefit in mutual funds, but only in debt mutual funds. Indexation doesn’t give benefit in equity mutual funds.
3. How does indexation help in saving the capital gain tax?
Indexation adjusts for the effects of inflation in the original investment during the tenure of the holding. It leads to an increase in the cost of acquiring. So, when the cost of acquiring will increase, the taxable income will decrease leading to lower capital gain taxes.
4. How to calculate the benefit of indexation?
The formula used to calculate the benefit of indexation is:
Cost of acquiring after indexation = Original cost of acquiring * (CII of the sale year/CII of the purchase year).
5. Does indexation benefit also apply to short-term capital gains in debt funds?
No, indexation benefits are not applicable in the case of short-term capital gains (holdings less than 3 years). It is only applicable to the long-term capital gains (holdings greater than 3 years) on debt mutual fund investments.
6. What is the minimum holding period to get the benefit of indexation?
The mutual fund units have to be held for a period of at least 36 months to get the benefit of indexation. If the holding period is less than 36 months then investors will not be eligible to get the benefit of indexation.
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