How Indexation Benefit Can Help Save Tax On Debt Mutual Funds
MAS Team | 21 January 2022
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Any person who is selling real estate, shares, mutual funds or jewellery that is owned by him/her, needs to pay income tax on gains. Such gains are taxed under the head ‘capital gains’ that arise out of such sale. Capital gains is nothing but profit on sale of capital assets. Capital assets are defined to include real estate, mutual funds, stocks, shares, bonds, and jewellery.
 
The Income Tax Act defines what is capital gain and what kind of assets are covered for the purpose of taxing capital gains. It also provides a method for computation of capital gains. Capital gains is divided into short-term (STCG) and long-term capital gains (LTCG) depending upon the period for which an asset is being held and method of computation varies based on the nature of capital gain.
 
Indexation plays an important role in calculating long term capital gains or losses on your investments. Indexation will reduce your overall tax liability by adjusting the purchase price of the underlying asset or investment. You will be able to realise higher gains as you can adjust them against the rate of inflation of the year of purchase and sale. 
 
In this blog post, we shall understand the concept of indexation, what it is? how does it work? and most importantly, how can one use indexation to reduce taxes?
 
Due to economic factors, the value of asset/any item inflates over a period of time. A kilo of tur dal costs Rs125 currently, but may have been available at less than half the price in 2001. Hence, it may not be fair to tax gains which is computed without factoring this inflation.
 
The term “indexation” generally represents a system or technique used by governments and organisations to align prices and asset values to present conditions. In other words, think of indexation as an inflation-adjuster that allows modifying the price of goods and services based on a pre-determined index. 
 
This pre-determined index can be anything but mostly takes into account the prevailing economic conditions like inflation, cost of living, wages, input prices, and other macroeconomic factors In the case of mutual funds, indexation is done by adjusting the purchase price of a unit. 
 
This adjustment is often aligned with the inflation rate that persisted between the time the mutual fund unit was bought and the time when it was sold. So as a formula, the indexed cost of acquisition is simply the purchase price multiplied by the index value in the year of sale divided by the index value in the year of acquisition.
 
Thus, Cost Inflation Index (CII) is fixed by the Government of India in its official gazette to measure inflation and is used in computing long-term capital gains in relation to the sale of assets. Indexation means adjustment in the cost of a capital asset based on the CII. This inflated cost is considered to be the cost of acquisition while computing profit or loss on the sale of capital asset.
 
The CII is a number that is notified by the Central Board of Direct Taxes and represents the general direction of prices which, in the case of India, is generally upwards thereby signaling the inflationary trend of the country. More specifically, the CII is calculated as 75% of the average rise in the preceding year’s Consumer Price Index (CPI). 
 
Cost Inflation Index = 75% of the average rise in the Consumer Price Index* (urban) for the immediately preceding year.
 
CII Previous Year values can be found here.
 
When the indexation benefit is applied to “Cost of Acquisition” (purchase price) of the capital asset, it becomes “Indexed Cost of Acquisition”.
 
Initially, 1981-82 was considered as the base year. But, taxpayers were facing hardships in getting the properties valued which were purchased before 1st April 1981. Tax authorities were also finding it difficult to rely on the valuation reports. Hence, the government decided to shift the base year to 2001 so that valuations can be done quickly and accurately. So, for a capital asset purchased before 1 April 2001, taxpayers can take higher of actual cost or FMV as on 1 April 2001 as the purchase price and avail benefit of indexation. 
 
Indexation is an important and effective tool that softens your tax liability on long-term capital gains and plays a big part in improving the attractiveness of debt mutual funds. In fact, indexation is not limited to just debt funds but is also used to calculate the inflation-adjusted price of other assets like land, building, gold jewelery except for direct equities and equity mutual funds where indexation does not apply. 
 
Indexation benefit for debt mutual funds (MFs) 
 
In debt mutual fund taxation, if the debt fund was sold before three years, it is known as short term capital gains. The total profit earned is taxable depending on the annual income of the investor.
 
However if the debt fund is held for more than three years, the it is known as long term capital gains. LTCG tax on debt mutual funds is levied  (after indexation benefit) at 20% plus surcharge and cess on the taxable capital gains 
 
 
However, in case an investor incurs capital loss during the sale of NAV units of debt mutual funds, it is exempted from income tax calculations for the respective financial year. 
 
The longer your debt MF holding period, the higher will be the real indexation benefit, and vice versa.
 
You have to invest in the growth option (as against dividend option) of a debt MF and your holding period should be 3 years or longer. You get indexation benefit for each financial year you stay invested. 
 
The CII number for the financial year is declared usually in the second quarter of that year i.e. July to September or as an exception, in the third quarter, for example, in October. Hence you can plan accordingly. 
 
However, if you redeem in say April or May, it may lead to complications for NRI investors due to incidence of tax deduction at source (TDS) as the MF cannot give benefit of indexation for that year. However, the NRI investor can claim it later while filing returns.
 
Indexation calculation for debt funds 
 
The real value of profits can be determined by using the following indexation formula – 
Actual value after indexation = original amount * (CII of the current year/CII of the purchasing year.)
 
Illustration of indexation benefit:
 
For instance, assume that Preeti had invested Rs1 lakh in a debt mutual fund in 2014. Four years later, she decides to redeem her investment at Rs 1.8 lakh in 2018, thereby realising a profit of Rs80,000.
 
The nominal value of investment realized can be determined by the indexation formula –
 
Actual purchase value after indexation = original amount x (CII of the current year/CII of the purchasing year) 
 
In 2014, the CII of India was 240. In 2018, the value increased to 280.
 
Inflation-indexed worth = 1,00,000 * (280/240) = Rs. 1,16,666.67. 
 
Therefore, total gains realised = Redemption Value-Indexed Cost Rs (1,80,000-1,16,666.667)= Rs 63,333.33 
This value is subjected to tax at 20%. 
 
Tax payable = 20/100 * 63,333 = Rs 12,666.67 
Total realisable profit= Redemption value-Tax payable 
Rs (80,000-12,666.67)= Rs 67,333.33 
 
 
There is no denying that the knowledge of indexation is very important for anyone who invests in debt mutual funds and that, it can significantly reduce one’s tax liability.