What is Indexation and How It Helps Reduce Capital Gains Tax On Debt Fund Returns

While we consider making long term investments, out of the various objectives we have, the most pressing one is to earn returns. But when we focus on these returns, we generally assume the return on paper to be our actual returns, ignoring the effect of taxation. Whereas in reality, it is the post-tax returns that matters.

What makes predicting or even calculating the post-tax return difficult is the different rules and rates for different avenues. One such rule (or benefit) that actually helps in reducing your tax outgo is Indexation.

In this blog, we will look at Indexation, how it works, and how it helps you bring down the taxes you pay on your debt mutual fund investments.

What is Indexation?

Indexation is the process through which you adjust the purchase price of an asset to account for inflation between the time you bought and sold it.

Sounds confusing? Well, that’s because it is a slightly tricky concept. Let’s try simplifying it for you.

Suppose mangoes today cost Rs. 100 per dozen and you buy and store them. Now after a month, the price shoots up to Rs. 110 per dozen. Same mangoes, but their cost today is Rs. 110 now. You now sell them, and because you had ripe-ready-to-eat mangoes, you got Rs. 120 for your dozen.

In this case, your profit from the transaction will be something like this:

So, you will make a profit of Rs. 20 from the transaction. But remember today, the purchase price of that dozen in the market is Rs. 110. So for taxation purposes, the government allows you to adjust your purchase price to reflect this increase due to inflation. So your gains for taxation purposes will look like this:

As you can see, due to the benefit of indexation, your taxable gains decreased Rs.20 to Rs.10, which would also decrease your tax liability.

Indexation Rates: Cost Inflation Index (CII)

Indexation rates are calculated using the Cost Inflation Index (CII). Cost Inflation Index (CII) is a figure issued by the Central Government every year that represents the year’s inflation. As you would have guessed, the number keeps changing. If in a year, inflation was high, the CII number would be high and vice-versa.

The CII is 75% of the average rise in the Consumer Price Index (CPI) for the previous year. Consumer Price Index compares the current price of a basket (which represents the economy and is a mix of goods and services) with that of previous year to calculate the increase in prices.

CII for the last 15 years are mentioned down below.

Benefit of Indexation: How Does This Work in Debt Mutual Funds?

Now you have the CII number for the year when you invested and the year you redeemed. How is this used to calculate the indexation benefit so that your tax outgo on long term capital gains from Debt Funds can be reduced?

Let’s take an example of investment in a Debt Fund to understand this.

Shashi invested Rs. 1 lakh in a debt mutual fund scheme in September 2016 (FY 2016-17). After 4 years, in October 2020 (FY 2020-21) he redeemed his investments and got Rs. 1,50,000. So his capital gains were Rs. 50,000

Since he held this investment for a period of more than 3 years, the gain on his investment is categorized as Long Term Capital Gain (LTCG) and he will get the benefit of indexation and won’t pay tax on entire Rs. 50,000.

In order to find the taxable gains after indexation benefit on Debt Fund returns, the original purchase price is adjusted for inflation using CII. The formula that is used is

Inflation-Adjusted Purchase Price = Actual Purchase Price X (CII in the year of sale/CII in the year of purchase)

In this case, the taxable capital gains after indexation benefit will be calculated like this:

As you can see, because of the benefit of indexation, Shashi will be liable to pay capital gains tax on only Rs. 35,984.85 rather than on the entire capital gains amount of Rs. 50,000.

As specified by the Income Tax Act, the rate of tax on Long Term Capital Gains (LTCG) of Debt Funds is 20% with Indexation benefit. So, the total capital gains tax that Mr. Shashi will have to pay is Rs. 7197. The below table shows the difference between capital gains tax payable by Mr. Shashi with and without the benefit of indexation:

As you can see, due to the benefit of indexation applicable to LTCG of Debt Funds, Mr. Shashi’s tax liability was reduced by over Rs. 2800 in this case.

Bottom Line:

Indexation is a powerful tool to save tax when it comes to investing in debt mutual funds. It reduces your inflationary gains that take a toll on your returns by attracting heavy tax. But remember, you need to stay invested for at least 3 years to take advantage of this benefit.