Investments come with risks, and the more the risk, the higher the reward, which is taxed as a capital gain. Indexation is crucial in this case. By restricting the purchase price of the investment or asset, indexation serves to reduce the overall tax liability.
What is the meaning of indexation?
As the market fluctuates, investors are exposed to more risk. The investor’s returns are not as expected due to the unpredictability of the market and growing inflation. Furthermore, while computing capital returns on the sale of an asset or investment, the income tax law takes into account market volatility and inflation.
Indexation comes to the rescue in this situation. The Hindi word for indexation is suchikaran. Indexation, as the name implies, is a system of economic control in which wages and interests are linked to a cost of living index in order to mitigate the consequences of inflation.
As a result, indexation aids in the control of an investment’s gain or loss. It is a method of adjusting income payments using a price index in order to maintain an individual’s purchasing power after inflation. This also aids in the prevention of taxation draining investment earnings.
Indexation has the benefit of assisting in the regulation of investment purchase prices, and it is applicable to long-term investments such as debt funds and other assets. It allows you the option of increasing the asset’s purchase price, which helps to mitigate the negative cost impact of inflation.
Indexation makes investing a profitable scheme since it increases the likelihood of a substantial profit, even after taxes.
How are capital gains calculated in a Debt Mutual Fund?
In simple words, the capital gain is the profit or return derived from the sale of an asset, whether tangible (property, house, etc.) or intangible (stocks, bonds, etc). (bonds, equity mutual funds, mutual fund, etc). The difference between the asset’s acquisition price and its selling price is known as a capital gain.
Mr. Varun, for example, placed Rs. 5 lakhs in a Debt Mutual Fund in 2015. In the year 2020, the fund’s worth is expected to be Rs. 8 lakh. Mr. Varun’s investment yielded a 3 lakh long-term capital gain.
Long-term and short-term capital gains are the two forms of capital gains on debt mutual funds. A long-term capital gain is defined as an asset held for more than 36 months, whereas a short-term capital gain is defined as an asset held for less than 12 months.
|Types of Capital Gains on Debt Mutual fund||Period||Applicable Tax Rate|
|Short Term Capital Gain||Less than 12 months||Taxed as per individuals income tax slab|
|Long Term Capital Gain||More than 36 months||20% (with indexation benefit)|
How to calculate indexation benefit?
The Cost Inflation Index (CII), which is released by the Central Government every financial year, is taken into account in order to restrict capital gains.
Long-term capital gain on a debt mutual fund that also benefits from indexation.
The following formula is used to calculate the actual worth of an investor’s profit:
Cost of purchase * (CII of the year of selling/ CII of the year of buying) = actual profit value (after indexation)
Let’s take a look at this with the aid of an example:
Indexation example and calculation
Assume MR. Arun bought a 7000-unit Debt Mutual Fund for Rs. 23 in the Financial Year 2012-13 and sold it for Rs. 36 in the Financial Year 2019-2020. The units are eligible for indexation because they have been held for longer than 36 months.
In the aforementioned transaction, the profit is Rs. 91000 (36-23).
Let’s start with the inflation-adjusted Purchase Price: 33.235 = (289/200)*23 (For Cost Inflation Index refer to the table below)
We now compute the LTCG for the same:
(Rs. 36 – Rs. 33.235) x 7000 = Rs. 19,355
For the above-mentioned case, the tax calculation will be as follows:
20% tax on Rs. 19,355 = Rs. 3,871
How is Indexation applied to Debt Funds?
Long-term Debt Mutual Funds benefit from indexation since it reduces their tax liability. Using the cost inflation index, indexation allows you to increase the buying price. Let’s have a look at how indexation works in Debt Mutual Funds:
Assume Mr. Ram bought a 5000-unit Debt Mutual Fund for Rs. 18 in the 2012-13 fiscal year and sold it for Rs. 27 in the 2018-2019 fiscal year. The units qualify for indexation benefits because they were held for more than 36 months.
In the aforementioned transaction, the profit is 5000 (27-18) = Rs. 45000.
Let’s start with the inflation-adjusted price – Inflation-adjusted Purchase Price: Inflation-adjusted Purchase Price: Inflation-adjusted Purchase Price: Inflation-adjusted Purchase Price 25.2 = (280/200)*18 (For Cost Inflation Index refer to the table below)
Now we’ll figure out what the LTCG is for the same:
Rs. 9000 = 5000 x (Rs. 27 – Rs. 25.2)
For the above-mentioned example, the tax calculation will be:
On Rs. 9000, a 20% tax is applicable, bringing the total to Rs. 1800.
Long-term capital gains are taxed at a rate of 20% for Debt Funds. Other than traditional Fixed Deposits, this is a much superior option for investors.
The table below well illustrates the preceding example:
|Sale Consideration||5000 * 27||Rs. 135,000|
|Cost of purchase||5000 * 18||Rs. 90,000|
|Net Gain (without indexation)||5000 * (27 – 18)||Rs 45,000|
|Indexed Cost of purchase|
(CII for the year 2018-19 / CII for the year 2012-13) * Cost of Purchase
|Net Gain (With Indexation)|
|Rate of Tax||20%|
|Long Term Capital Gain tax (without indexation benefit)||45000*20%||Rs 9,000|
|Long Term Capital Gain tax (with indexation benefit)||9000*20%||Rs 1800|
|Tax saving due to Indexation||9000 – 1800||Rs 7,200|
Benefits of Indexation
Indexation is one of the most well-structured and trustworthy provisions for investors looking to save money on their long-term investments. Indexation allows investors to enhance the asset’s purchasing price, so reducing the negative impact of inflation on costs.
Indexation makes debt mutual fund investing a profitable plan since it allows investors to generate a healthy profit even after tax deductions. By applying the cost of inflation index, indexation aids in the reduction of long-term capital gains, lowering taxable income.
Index-linked investments are preferred over traditional fixed deposits due to the various benefits of indexation, including lucrative returns, stability, and liquidity.
Cost inflation index value – CII
The cost inflation index is a formula for calculating long-term capital gains from the sale of assets. Any profit made from the sale of an asset (tangible or intangible) is considered a capital gain.
The cost inflation index of the government is used to index the rate of inflation (CII). The central government determines the index’s value, which is updated annually on the Income Tax Department’s website.
The table below shows the rate of inflation from 2009 until 2020:
Indexation tables 2009-2020
The government has designated a year as the base year, and the CII is calculated using that year. In order to determine the increase in inflation, the government considers the index from previous years and compares it to the base year.
What You Should Know: The base year will be modified from 1981 to 2001, as our finance minister just revealed.
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