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. 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 through the provisions of indexation benefit while calculating the capital gains on investments.

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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/ 36 months in equity funds/ other 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. 

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. The CII Cost Inflation Index (CII) notified 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

 

Source: incometaxindia.gov.in

As such, the calculation of capital gains may be summarized as below:

Capital Gain = Redemption Value – Actual Cost of Investment

Capital Gain where indexation is allowed = Redemption Value – Indexed Cost of Investment

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. 

Calculation of Indexation  

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. While the tax rate on LTCG on debt funds is 20%, the effective tax for Mr. A on this investment comes to Rs. 3,200, resulting in an effective tax rate of 9.14% of the absolute returns generated. 

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.  

Note: The tax provisions, as mentioned in the article, are for illustrative purposes only, and are updated as per the Union Budget 2020 passed by the Parliament. 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