What is indexation, and how the tax burden is reduced with indexation?

Indexation benefits for the tax liability!

Indexation benefits for the tax liability

When an asset is sold, the seller needs to pay some tax on the gains from the sale. One needs to pay these capital gains on selling assets like property, jewellery, bonds, etc. Indexation, as we already discussed, is the process by which the purchase price of a product is adjusted to reflect the effect of inflation. The Income Tax Department permits indexation mainly if there is inflation. This helps in minimizing the income tax burden. One thing you must remember here is that you need to own the asset to be sold for at least the number of years specified. This time period, however, can vary and relies upon the kind of asset you are holding. For example, the minimum period for you to hold an immovable property before availing of the indexation benefit is two years. However, in the case of non-equity funds, it is three years.

This could be confusing or seem like a tricky concept for many people. So let us understand this by a simple example. Let us say that we buy and store 1 kg of apples today that cost Rs. 100, but the price increases to Rs. 110 per kg after some days. We then sell the juicy ripe apples at Rs. 120 per kg. Thus, we profit Rs. 20 from the sale even when the cost price is Rs. 110. Therefore, the government allows us to adjust the cost price to reflect inflation. Thus, our taxable gain from the sale equals Rs. 10, not Rs. 20, which is our actual profit. This is thus the indexation benefit. This is how indexation reduces tax liability or tax burden.

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Cost Inflation Index (CII)

The Cost Inflation Index, or CII, is used to calculate yearly indexation rates. It is a metric or figure issued by the central government that calculates the increase in the cost price of various goods every year due to inflation. 

The benefit of Indexation on Non-Equity Funds

Let us take another example to understand how indexation affects non-equity mutual funds. Let's say you invested Rs. 1lakh in 2005 while the CII was 100. The current CII is 284, and you wish to sell the same asset today. Your purchase cost now would be adjusted to Rs. 2.84 lakhs. This is calculated using this formula - (Rs 1 lakh x 284/100). Assuming the redemption value is Rs. 10 lakhs, the profit would be Rs. 9 lakhs without indexation. However, on applying indexation, with redemption value being the same, profit would be Rs. 7,16,000 on a purchase value of Rs. 2.84 lakhs. On imposing a 20% tax on both cases, the tax to be paid without indexation would be Rs. 1,80,000, while the tax to be paid after indexation would be Rs. 1,43,200. Thus, there is a difference of Rs. 36,800 between the taxes paid in either case. This is how indexation can minimize your tax. 

Thus, on adjusting the purchase price after indexation, our capital gains get reduced to a great extent. Thus, the taxable capital gains also get reduced, which significantly minimizes your tax burden. 

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The benefit of Indexation on Debt Mutual Funds

Let's consider a hypothetical situation assuming you invested Rs. 1 lakh in a debt mutual fund scheme in April 2010. After five years, in May 2015, you redeem the investment and get Rs. 1,60,000. Here, Rs. 60,000 would be your capital gain. Because you held on to the investment for more than three years, the gain is classified as LTCG or Long Term Capital Gain. Thus, indexation would be applied here, and you would not be required to pay tax for the entire capital gain of Rs. 60,000. This is because the actual purchase price is adjusted after CII due to inflation while holding the investment.

Thus, considering the CII for 2010 to be 224 and for 2015 to be 316, the purchase price after indexation would be Rs. (1,00,000 x 316/224) which equals Rs. 1,41,071.42. Amount redeemed in 2015 is Rs. 1,60,000. Thus, the taxable capital gains after indexation would be Rs. (1,60,000.00-1,41,071.42) = Rs. 18,928.58. This is how you will be required to pay tax on a capital gain of Rs. 18,928.58 after indexation instead of the total capital gain of Rs. 60,000.

This is how indexation plays a very important role in reducing the tax burden.

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Mutual funds : Taxation & Indexation


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