Indexation – Definition, Benefits & Calculation

As per the tax structure of our country, an investor gets the benefit of indexation on the long term gains from debt mutual funds 

Given below are the details of indexation on mutual funds in India.

What is Indexation? – definition and explanation

Indexation is the benefit of inflation adjustment that is provided to the investors when they have held their debt funds for a long term. When an investor redeems his long-term debt mutual funds (held for more than 3 years), the capital gain is adjusted to incorporate inflation which is referred to as indexation benefit. Indexation helps an investor reduce their tax liability by increasing the purchase price on account of inflation.

By the way, this benefit is available to many other asset classes like real estate, gold, stocks and shares of a listed or an unlisted company, etc. 

How does Indexation work?

Inflation eventually reduces the value of money over time.

Let us take an example of a fund having NAV of Rs.100 today and it increases to Rs. 150 after 5 years. The investor has received a capital gain of Rs. 50 in this case over a period of 5 years. If the fund is a debt fund, then the investor will get the benefit of indexation on the long term capital gains. 

Indexation is calculated on the basis of a Cost of Inflation Index (CII). This is a number notified by the Ministry of Finance for each financial year. Investors can get this number from the Ministry website or from the website of Income Tax Department of India.

The formula for Long term capital gains based on indexation is given below.

Long-term Capital Gain = Selling Price of an Asset – Indexed Cost of an Asset

Indexed Cost of an Asset = Purchase Price of an Asset x (CII in the year of sale/ CII in the year of purchase)

(Where CII = Inflation Index for the year in which the asset was sold)

Let us consider an example to better understand the benefit of indexation to an investor.

An investor has invested Rs. 50,000 each in a debt funds Fund A March 2018. The investor redeems Fund A at Rs. 75,000 after 3 years in March 2021. 

Having debt funds, the investor will get the benefit of indexation on fund B. The tax incidence on such funds with and without the benefit of indexation is explained below.

With the above example, we can see that indexation benefit provides a tax savings of Rs.1066 in long term capital gains on debt funds on account of increased purchase price.

Indexation Benefits

As discussed above, indexation helps the investor in saving tax liability. The benefit of indexation is only available on the debt funds and not on equity oriented funds. Investors can also get the benefit of indexation on hybrid debt oriented funds as they are taxed in line with debt mutual funds. 

Some benefits of indexation are mentioned below. 

• Reduction in taxability of the funds on account of increased purchase price or initial investment
• Provides an added advantage to debt funds over equity oriented funds

Indexation in Mutual Funds

Debt mutual funds mainly benefit from indexation. For your ready reference, here is the tax structure on various categories of mutual funds.

In case of hybrid mutual funds, if a fund holds more than 65% of its assets in debt, then it is categorised and taxed as a debt mutual fund. 

Calculation Of Indexation

The formula for calculating indexation is as follows:

Indexed Cost of Acquisition = Cost of Acquisition x (CII of Year of Sale / CII of Year of Purchase)

Here, the cost of acquisition is the original purchase price of the asset, and the CII is the Cost Inflation Index, which is published by the Income Tax Department of India. The CII is a measure of inflation that is used to adjust the cost of an asset over time.

To calculate the indexed cost of acquisition, you need to determine the CII for the year in which the asset was purchased and the year in which it was sold. You then divide the CII of the year of sale by the CII of the year of purchase and multiply the result by the cost of acquisition.

For example, suppose an investor purchased shares in a company in 2010 for Rs. 10,000 and sold them in 2022 for Rs. 20,000. The CII for 2010 was 167, and the CII for 2022 is 317. Using the formula above, the indexed cost of acquisition would be:

Indexed Cost of Acquisition = 10,000 x (317 / 167) = Rs. 19,042

So, the investor’s taxable capital gains would be calculated as Rs. 20,000 – Rs. 19,042 = Rs. 958. By adjusting the cost of acquisition for inflation, the investor is able to reduce their tax liability and keep more of their investment returns.

Conclusion

Mutual funds have been a preferred investment destination for millions of investors in India. The tax benefits on the investment play a crucial factor that influences the investment decision of any person. The indexation benefit on the debt oriented mutual funds provides the investors with an added advantage over similar investment options. Investors have to, therefore, choose the investment option carefully keeping in mind their investment goals and the post tax returns that can be availed on the mutual funds.

FAQs

1. What are the types of mutual funds based on asset classification?
Mutual funds are broadly classified under three broad categories as per asset classification. These categories are,

• Equity oriented mutual funds
• Debt oriented mutual funds
• Hybrid mutual funds 

2. Is the benefit of indexation available on equity oriented mutual funds?
No. Equity oriented mutual funds do not get the benefit of indexation on long term gains.

3. Where can an investor find the CII?
CII is the cost of the inflation index that is notified by the government for every financial year. This number is available on the website of the Finance Ministry and the Income Tax Department.

Related Links

• Taxation on Mutual Funds
• Long Duration Funds
• Floating Rate Fund
• Long term capital gain
• Gilt mutual funds with 10-year constant duration