Indexation is a process of adjusting the purchase price for Inflation mainly for calculating Long Term Capital Gains for Tax purpose. This is done so that the investor is taxed only on the actual capital gain after adjusting for Inflation.
Inflation reduces the value of money over a period of time. It helps in saving tax on capital gain and it is applied on long term investments in Real Estate, Gold and Debt Mutual Funds.
We all know 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.
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.
The Cost of Inflation Index (Price Index) used every year for this purpose if maintained and released by Income Tax department, and its available only for Long term gains.
How it Works?
To avail this benefit, we need to first adjust the purchase price effecting the Inflation. 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.
(CII of the year when units are sold / CII of the year when units are bought) * Original Purchase Price
This will give the Indexed Purchase Price of the Investment.
For Example – Mr Raj purchased 5000 units of a Debt mutual fund at NAV of Rs18 in the Financial Year 2012-13 and then sold at Rs 27 in the Financial Year 2018-19. There is a clear gap of 3 years from the Buy year and Sale year so we can Index the cost of acquisition.
The actual profit realised in this transaction is: 5000 units * 5 Rs (27–18) = Rs 45000
Let us arrive at the Inflation adjusted purchase price : ( 280 /200)*18 =25.2
( 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)
What is the indexed capital gain for the transaction:
5000 x (INR 27- INR 25.2) = INR 9000
Tax Rate On Long Term Capital Gains For Debt Funds
The tax rate for LTCG on Debt Funds is 20% plus other charges the net will be 22.8%.
Tax Calculation for our example
Applicable Tax: 22.88% of Rs 9000= Rs 2059 as against Rs.10296 (22.88% of Rs.45000)
Actual Gain is Rs. 45000 and after applying indexation gain is Rs. 9000. Tax on the actual is Rs. 10300 and after indexation is Rs. 2059 (Thus a substantial savings)
The tax rate is the same in this case but the way in which we arrive at the gain amount is the real benefit. If you come under 30% tax bracket the gain is much more. And this will benefit Debt fund investors vs Fixed Deposit investors. And you need to read this Blog of mine to know more about Debt funds.
Happy Indexing!
R♥Vi
Disclaimer: The information contained in this document is compiled from third party and publically available sources and is included for general information purposes only. Views expressed cannot be construed to be a decision to invest. The statements contained herein are based on current views and involve known and unknown risks and uncertainties. The recipient(s) before acting on any information herein should make his/her/their own investigation and seek appropriate professional advice.
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