What is Indexation in mutual funds?

Published On: 12-Aug-2020

It is a known fact that the purchasing power of money reduces over time. An Rs. 2000 note today will fetch lower value a year later and further lower a decade later. Similarly, a Rs. 100 item will most likely not be available at the same rate a year later and available at much higher rates 10 years later. This happens due to the increase in prices of raw materials, input services etc. In normal parlance, this is referred to as inflation, which reflects the increase in prices of commodities and services across different periods. Income tax laws also conceptualise this reality and tax only the real returns (adjusted for inflation) through the provisions of indexation benefit while calculating the capital gains on non-equity fund investments held for 36 months or more.

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How are Capital Gains Calculated?

When it comes to calculating capital gains on mutual fund investments, the investor needs two primary inputs – the invested amount and the redemption value. The difference between these two figures represents the actual returns generated by the investors. Such returns are classified into Short Term Capital Gains (STCG) and Long Term Capital Gains (LTCG) depending upon the type of mutual fund scheme and the holding period. 

For equity-oriented funds, the specified period of holding for categorisation of capital gains as LTCG is 12 months. For other funds like debt funds, gold funds, etc., such a period is 36 months. As such, the gains from the mutual fund units held for less than 12 or 36 months in equity oriented funds or other than equity oriented funds respectively, the gains will be classified as STCG. For units with a longer holding period, the gains will be classified as LTCG. The tax rates also differ on different types of capital gains as summarized below:

Particulars

Holding Period

Type of Gain

Tax Rate

Equity oriented funds

Less than 12 months

STCG

15%

12 months or more

LTCG

10% without indexation *

Other funds, e.g., debt funds, gold funds, etc.

Less than 36 months

STCG

Regular tax rates

36 months or more

LTCG

20% with indexation

 

* The investors may also avail of an aggregate exemption of Rs. 1 lakh in a year towards LTCG from equity funds and equity stocks taken together. 

The calculation of capital gains may be summarized as below:

Short Term Capital Gain for Equity Oriented Funds = Redemption Value – Actual Cost of Investment
Long Term Capital Gain for Equity Oriented Funds = Redemption Value – Actual Cost of Investment
Short Term Capital Gain for Non-Equity Funds = Redemption Value – Actual Cost of Investment
Long Term Capital Gain for Non-Equity Funds = Redemption Value – Indexed Cost of Investment

As may be seen above, the benefit of indexation is allowed on calculating LTCG on non-equity funds like debt funds, gold funds, etc. However, such indexation is not allowed for equity-oriented funds.

What is the Indexation benefit?

Indexation refers to adjusting the cost of a capital asset, which is equivalent to the invested amount, to the prevailing inflation over the years. is notified by the Govt. every year to ensure uniformity in this regard. When the cost of investment is adjusted for inflation through Cost Inflation Index (CII), the effective taxable gains reduce to that extent. The Cost Inflation Index (CII) notified by the Govt. for different years is as under:

S. No.

Year

Value

1

2001-02

100

2

2002-03

105

3

2003-04

109

4

2004-05

113

5

2005-06

117

6

2006-07

122

7

2007-08

129

8

2008-09

137

9

2009-10

148

10

2010-11

167

11

2011-12

184

12

2012-13

200

13

2013-14

220

14

2014-15

240

15

2015-16

254

16

2016-17

264

17

2017-18

272

18

2018-19

280

19

2019-20

289

20

2020-21

301

21 2021-2022 317
 

Source: incometaxindia.gov.in

Just analysing the latest two CII figures, one can decipher that if an investment is made for Rs. 272 in the year 2017-18, it should be equal to Rs. 317 in the year 2021-22 and the gains only above Rs. 317 would be taxable. The gains from Rs. 272 to Rs. 317 during the period are considered on account of prevailing inflation and thus, not subject to taxation while calculating the Long Term Capital Gains from non-equity oriented funds.

Benefit of Indexation

With CII value being notified by the Govt. based on inflation figures over the years, the indexation benefit adjusts the value of an investment to calculate Capital Gains and effectively reduces the overall tax incidence on such returns by considering the impact of inflation over the years. The indexed cost of investment is calculated as below:

Indexed Cost of Investment = Invested Amount X CII for redemption year/ CII for the year of investment

The concept of indexation is further discussed in an illustrative example below:

Mr. A had invested Rs. 1 lakh during the year 2015-16 in a debt fund and redeemed the investment for Rs. 1.35 lakh during the year 2020-21. The absolute returns generated by Mr. A from this investment is Rs. 35,000. However, considering the holding period of around five years for an investment in a debt fund, he is eligible for indexation benefit. The indexed cost of investment comes out to be Rs. 1.19 lakh (Rs. 1 lakh X 301/ 254). As such, the taxable LTCG on this investment by Mr. A will be calculated as Rs. 1.35 lakh minus Rs. 1.19 lakh, i.e., Rs. 16,000 and Mr. A would be required to pay tax of Rs. 3,200 (20% on Rs. 16,000) on his overall gains.

This is how indexation helps the investors to lower the effective tax incidence on the returns generated from non-equity funds, i.e., debt funds, etc. and consequently increasing the post-tax returns.  

How does Indexation work in Debt Funds?

Income Tax laws have a provision of reducing the effective tax burden on long term capital gains that you earn. As evident from the Cost Inflation Index figures above, the indexation aims to reduce the taxable gains by adjusting the investments for inflation and effectively taxing only the real returns (absolute returns adjusted for the inflation impact). As illustrated in the example above, while the tax rate on LTCG on debt funds is 20%, the effective tax for Mr. A on his investment comes to Rs. 3,200, resulting in an effective tax rate of 9.14% of the absolute returns generated of Rs. 35,000. 

Conclusion

Given the benefit of indexation, the investors can suitably optimise their post-tax returns on non-equity funds, including debt funds, gold fundd, international equity funds, etc., as such benefit is allowed only while calculating the LTCG on non-equity funds. Such tax benefit of potentially lower tax impact also incentivises the investors to stay invested for longer, as indexation benefit is only applicable for long term capital gains on non-equity funds.

Disclaimers: The information set out above is included for general information purposes only and is not exhaustive and does not constitute legal or tax advice. In view of the individual nature of the tax consequences, each investor is advised to consult his or her or their own tax consultant with respect to specific tax implications arising out of their participation in the Scheme. Income Tax benefits to the mutual fund & to the unit holder is in accordance with the prevailing tax laws as updated for the Union Budget 2022 presented in the Parliament in February 2022. Further, the tax rates for capital gains will be as per the tax laws applicable on the date of redemption/ sale and not on the date of investment. Any action taken by you on the basis of the information contained herein is not intended as on offer or solicitation for the purchase and sales of any schemes of UTI Mutual Fund. Please read the full details provided in SID and SIA carefully before taking any decision.

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