Indexation benefit

Indexation benefit

Indexation is a method of accounting for inflation when calculating capital gains tax on an investment. When you sell an asset such as a mutual fund or a stock, you must pay tax on the difference between the purchase price and the sale price. However, if the asset was held for a long time, inflation could have eroded the value of your investment, so you may not have actually made a profit in real terms. Indexation benefit allows you to adjust the purchase price of the asset to reflect inflation, which reduces the amount of capital gains tax you have to pay.

Mutual funds are a type of investment vehicle where a group of investors pool their money together, and the fund manager invests the money in a diversified portfolio of stocks, bonds, or other securities. Mutual funds are a popular choice for many investors due to their ease of access, diversification, and professional management. Indexation benefit can be particularly advantageous for investors who hold debt mutual funds for a long time, as debt funds tend to generate capital gains in the form of interest income. In India, the Securities and Exchange Board of India (SEBI) has mandated that mutual fund units held for more than three years are eligible for indexation benefit. To calculate the indexed cost of acquisition, the cost of acquisition is multiplied by the cost inflation index (CII) of the year in which the asset was sold and then divided by the CII of the year in which the asset was acquired. This adjusted cost is used to calculate the capital gains tax, which can result in significant tax savings for long-term investors.

Indexation is a procedure by which the investor can get benefit from the fact that inflation has eroded one’s returns. Indexation works on the simple concept that if an investor buys a unit @ Rs. 10 and sells it @ Rs. 30 after 5 years, then the profit of Rs. 20 per unit needs to be adjusted for the inflation increase during the same time period. Inflation reduces purchasing power. This means that something that could have been bought for Rs. 100 when buying the unit @ Rs.10, would now have increased in price due to inflation. Thus the investor can now buy less for the same Rs. 100.

If for instance the inflation increases by 12% in the same period, then the adjusted cost of the unit purchased (at today’s price) would be:

Rs. 10 * (1 + 12%) = Rs. 11.2.

Hence, the profit would not be Rs. 20. It would be

Rs. 30 – Rs. 11.2 = Rs. 18.8

Thus, by adjusting the buying price for inflation, one has effectively negated the impact of inflation – thereby reducing profits. The tax liability would also be reduced in this process.

There is an option given to the investor on how he or she would prefer to calculate the tax.

In case one decides to forego the benefit of indexation, the profit would be Rs. 20 and a tax @ 10% would have to be paid on the capital gain. Thus he would pay tax of

20 x 10% = Rs. 2.

In case the indexation benefit is availed, the profit would be Rs. 18.8 (as previously determined). The investor would need to pay tax at a higher rate of 20%. Thus the tax liability would be 18.8 x 20% = Rs. 3.76. In this case, one would most likely opt for paying tax without taking the benefit of indexation as his tax liability is less in that case.