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What is Indexation? Definition, Benefits and Calculation of Indexation

Investments carry risks, the higher the risk the higher the returns and returns are subject to capital gain tax. Indexation here plays a vital role. Indexation helps in lowering down the comprehensive tax liability by regulating the purchase price of the investment or asset.

indexation
indexation

What is the meaning of indexation?

Investors are at a greater risk as the market changes significantly. With the unpredictable market scenario and rising inflation, the returns are not as expected by the investor. Moreover, the income tax law considers market instability and inflation at the time of calculating capital returns on the sale of an asset or investment.

Here indexation comes to the rescue. Indexation meaning in Hindi is suchikaran. As the name suggests indexation is a system of economic regulation where wages and interests are tied to the cost of living index in order to reduce the effects of inflation.

Indexation, therefore, helps in keeping a check on the gain or loss on an investment. It is a technique by which income payments are adjusted by means of a price index so as to maintain the purchasing power of the individual after inflation. This further aids in preventing draining of the returns on investments by way of tax.

The benefit of Indexation is to help one regulate the purchase price of the investment, which is applicable to long term investments, including debt funds and other assets. It gives you an alternative to increasing the purchase price of the asset which further helps in lowering the adverse cost impact caused by inflation.

Indexation makes investments a profitable scheme as it gives an investor a greater chance to earn a handsome profit even after-tax returns.

How are capital gains calculated in a Debt Mutual Fund?

Capital gain in simple terms is return or profit incurred by selling an asset be it tangible (property, house, etc) or intangible (bonds, equity, mutual fund, etc). Capital gain is basically the difference between the purchase cost of an asset and the selling price.

For example- Mr. Varun invested Rs. 5 lakhs in a Debt Mutual Fund in the year 2015. The value of the fund now stands at Rs. 8 lakh in the year 2020.  The long term capital gain earned on the investment by Mr. Varun is 3 lakh.

There are two types of  Capital Gains on Debt Mutual funds: Long Term and short term capital gain. Any asset held for more than 36 months is a long term capital gain whereas any asset held for less than 12 months is short term capital gain. 

Types of Capital Gains on Debt Mutual fundPeriod Applicable Tax Rate
Short Term Capital GainLess than 12 monthsTaxed as per individuals income tax slab
Long Term Capital GainMore than 36 months20% (with indexation benefit)

How to calculate indexation benefit?

In order to regulate the capital gain, the Cost Inflation Index (CII) is taken into consideration which is declared by the Central Government in every financial year. 

Long term capital gain on a debt mutual fund which comes with indexation benefit. 

The following formula is used to determine the actual value of profit gained by an investor :

Actual value of profit (after indexation) = cost of purchase * (CII of the year of selling/ CII of the year of purchase)

Let us now see this with the help of an example :

Indexation example and calculation

Suppose, MR. Arun purchased Debt Mutual Fund of 7000 units at Rs. 23 in the Financial Year 2012-13 and later sold it at Rs. 36 in the Financial Year 2019-2020. As the units were held for more than 36 months the same qualifies for indexation benefit.

The profit realized in the above transaction is 7000 (36-23) = Rs. 91000

Let us first arrive at the Inflation-adjusted Price –

Inflation-adjusted Purchase Price : (289/200)*23 = 33.235 (For Cost Inflation Index refer to the table below)  

Now we calculate the LTCG for the same :

7000 x (Rs. 36 – Rs. 33.235) = Rs. 19,355

The tax calculation for the above-stated example will be :

Applicable tax of 20% on Rs. 19,355 = Rs. 3,871 

How is Indexation applied to Debt Funds?

Indexation helps in saving taxes on long term Debt Mutual Funds. Indexation allows one to raise the purchase price using the cost inflation index. Let us now see how indexation is applied in Debt Mutual Fund:

Suppose Mr. Ram purchased Debt Mutual Fund of 5000 units at Rs. 18 in the Financial Year 2012-13 and later sold it at Rs. 27 in the Financial Year 2018-2019. As the units were held for more than 36 months the same qualifies for indexation benefit.

The profit realized in the above transaction is 5000 (27-18) = Rs. 45000

Let us first arrive at the inflation-adjusted price –

Inflation-adjusted Purchase Price : (280/200)*18 = 25.2 (For Cost Inflation Index refer to the table below)  

Now we calculate the LTCG for the same :

5000 x (Rs. 27 – Rs. 25.2) = Rs. 9000

The tax calculation for the above-stated example will be :

Applicable tax of 20% on Rs. 9000 = Rs. 1800 

Tax Rate on Long Term Capital Gain for Debt Funds is 20%. This is a much better option for investors other than the conventional Fixed Deposits.

The above example is well illustrated through the table below:

Sale Consideration 5000 * 27Rs. 135,000
Cost of purchase5000 * 18Rs. 90,000
Net Gain (without indexation)5000 * (27 – 18)Rs 45,000
Indexed Cost of purchase
(CII for the year 2018-19 / CII for the year 2012-13) * Cost of Purchase
5000*18*280/200Rs 126,000
Net Gain (With Indexation)
Rs 9,000
Rate of Tax20%
Long Term Capital Gain tax  (without indexation benefit)45000*20%Rs 9,000
Long Term Capital Gain tax  (with indexation benefit)9000*20%Rs 1800
Tax saving due to Indexation9000 – 1800Rs 7,200

Benefits of Indexation

One of the most structured and reliable provisions which are considered a boon for investors in saving tax on their long term investments is indexation. Indexation gives the investors an opportunity to increase the purchase price of the asset which in turn helps in lowering the adverse impact on the cost caused by inflation.

Indexation makes investments in debt mutual funds a profitable scheme as it gives investors an opportunity to earn wholesome profit even post-tax deductions. Indexation helps one in reducing the long term capital gain by using the cost of inflation index which in turn lowers the taxable income.

Owing to having multiple benefits of indexation like yielding profitable returns, bringing stability and providing liquidity, index-linked investments are chosen over the conventional fixed deposits.

Cost inflation index value – CII

The cost inflation index is a method by which long term capital gains are calculated from the sale of the assets. Any profit incurred by way of selling an asset (tangible or intangible) is capital gain. 

The rate of inflation used in indexation is taken from the Government’s cost inflation index (CII). The value in the index is determined by the Central Government and is updated in the Income Tax Department’s website every year.

Below is the table showing the inflation rate from the year 2009- 2020:

Indexation tables 2009-2020

Si.NoYearCII
12009-2010148
22010-2011167
32011-2012184
42012-2013200
52013-2014220
62014-2015240
72015-2016254
82016-2017264
92017-2018272
102018-2019280
112019-2020289

The Government has set a specific year as the base year and thus calculates the CII based on that same year. In order to ascertain the rise in inflation, the Government takes into consideration the index of the other years, and the same is compared to the base year. 

Did you Know:- Our finance minister has recently announced that the base year shall be changed from 1981 to 2001.

Published on May 22, 2020