Investing in mutual funds can be a profitable decision, but it is crucial to understand the details of taxation. One such essential aspect of taxation is indexation, a powerful tool that allows investors to calculate profits and, importantly, reduce tax liabilities more accurately. In this comprehensive guide, we will discuss the technical details of indexation, its calculation method, and how it brings significant benefits to investors in the mutual fund space.
Indexation Example
Let’s consider apples in this indexation example. Suppose you buy a dozen apples today for Rs. 100 and store them. After a month, the price increases, and now the apples are selling for Rs. 110 per dozen. You sell the apples for Rs. 120 because they are ripe and ready to eat. Your profit from the transaction is:
• Purchase Cost of Apples: Rs. 100
• Selling Price of Apples: Rs. 120
• Profit from Sale: Rs. 20
However, the current market price for a dozen apples today is Rs. 110. For tax purposes, the government allows you to adjust your purchase price to account for inflation. Therefore, your taxable gains will be calculated as follows:
• Selling Price of Apples: Rs. 120
• Current Market Price of Apples: Rs. 110
• Taxable Gains from the Sale: Rs. 120 – Rs. 110 = Rs. 10
Thanks to indexation, your taxable gains decrease from Rs. 20 to Rs. 10, ultimately reducing your tax liability.
What is Indexation in Mutual Funds?
Are you concerned that inflation may lower your returns? Does the income tax legislation consider inflation when determining capital gains from the sale of investments? Give up worrying and begin indexing!
It is the process of adjusting the purchase price of an asset, such as stocks, bonds, or real estate, based on the current inflation rate. The reduction is calculated using the official measure of inflation. It is typically represented by the Consumer Price Index (CPI) and is meant to account for inflation. It assists investors in the event of a gradual decline in the purchasing power of the asset. As a result, only profits that exceed inflation are taxed, which ensures a fair tax system.
Please note that not all Mutual Funds are eligible for indexation benefits. Hybrid Mutual Funds maintaining 35% to 65% equity exposure are eligible for indexation benefits.
What is The Index Rate or Cost Inflation Index (CII)
As a tool for calculating the indexation rate, the Consumer Price Index (CPI) is the source of the Cost Inflation Index (CII), which measures inflation. This CII amount has been set by the central Govt. every year according to year inflation. For the last 10 years, CII has been as follows:
| Financial Year | Cost Inflation Index (CII) |
| 2020-21 | 301 |
| 2019-20 | 289 |
| 2018-19 | 280 |
| 2018-19 | 272 |
| 2016-17 | 264 |
| 2015-16 | 254 |
| 2014-15 | 240 |
| 2013-14 | 220 |
| 2012-13 | 200 |
| 2011-12 | 184 |
Indexation Formula
To calculate the indexed cost of purchase, you can use the following formula:
Indexation=Original cost of acquisition×CII of the given year/CII of the base year
Where:
• CII of the given year is the Cost Inflation Index for the year of sale.
• CII of the base year is the Cost Inflation Index for the year of purchase.
Step-by-Step Calculation of Indexation
• Determine the acquisition cost of the asset, including transaction charges.
• Find the CII (Cost Inflation Index) of the base year, which corresponds to the year of purchase.
• Find the CII of the given year, which corresponds to the year of sale.
• Divide the CII of the given year by the CII of the base year.
• Multiply the result obtained in step 4 by the original acquisition cost.
Taxation Structure for Long-Term Capital Gains
For instance, Mr. A acquired 5000 units of Hybrid Mutual Fund (35% – 65% equity exposure) XYZ at Rs 18 per unit in the Financial Year 2012-13 and subsequently sold them at Rs 27 per unit in the Financial Year 2018-19. Since the holding period exceeded 36 months, this transaction is eligible for the indexation benefit.
The profit from the transaction is calculated as follows:
5000×(27−18)=Rs 45000.
Next, we determine the inflation-adjusted purchase price:
Inflation-adjusted Purchase Price = (280/200) × 18 =25.2
Then, the Long-Term Capital Gain (LTCG) for the transaction is calculated:
5000×(Rs 27−Rs 25.2)=Rs 9000
So, after adjusting for inflation, the LTCG Mr A generates will be Rs 9000. 20% tax will be applicable on this amount. Without the indexation benefit, the LTCG would’ve been Rs 45,000, leading to a higher tax liability.
(Here, the Cost Inflation Index for 2018-19 is 280, and for 2012-13, it is 200, as per the figures provided by the Income Tax Site.)
Benefits of Indexation
• It facilitates the adjustment of an asset’s value based on the inflation level in the economy.
• It alleviates the tax burden for investors by adjusting the acquisition cost according to inflation, thereby reducing the taxation on gains.
• It encourages long-term investing, as investors can benefit from indexation advantages.
Conclusion
Indexation proves to be a robust strategy for reducing tax implications when investing in hybrid mutual funds maintaining 35% – 65% in equity oriented instruments. By accounting for inflationary gains, it helps mitigate the impact of taxes on your returns. However, it’s important to note that this benefit is accessible only if you remain invested for a minimum of 3 years.
FAQs
1. Are all mutual funds eligible for indexation benefits?
Not all mutual funds are eligible for indexation benefits. Mutual Funds maintaining 35% – 65% gross equity exposure are only eligible for indexation benefits.
2. Is indexation beneficial for short-term investments in mutual funds?
Indexation is only applicable for long-term investments, kept for over 36 months, for specific mutual funds maintaining 35% – 65% gross equity exposure.
3. How can investors incorporate indexation in their investment strategy?
Investors should focus on long-term goals, select funds with indexation benefits, and understand the taxation implications. The best way to make an investment strategy is to choose the right fund, set goals, diversify your portfolio, and consult a financial advisor who can help you choose the right investment.
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