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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.

## What is Indexation?

Indexation applies to debt funds only. It is a technique used to adjust the purchase price of your debt fund for inflation. It helps to counter the erosion in the value of the investment over a period of time. The income tax department recognises that one needs to increase the purchase price of the investment so that it reflects inflation-adjusted true price in the year in which it is sold.

## 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. However, from April 1st 2023, LTCG benefit is no longer available for debt funds. The capital gains will be taxed as per the investor’s income tax slab rate.

The following formula is 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 holding period is 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

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 holding period is 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.

Summarizing the above example as follows:

## 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. Furthermore,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.