How Does Indexation Impact Tax Charged on Gains from Debt Mutual Funds?

When you invest, you aim to maximize your returns. However, inflation eats into your actual returns. Additionally, when you exit your investments, you need to pay capital gains tax. Fortunately, the government offers a solution for this, which is known as the indexation benefit.

The basic reasoning for indexation benefit is to ensure you pay tax only on your returns after being adjusted for inflation. This allows you to pay 20% capital gains tax after taking advantage of indexation benefit.

Indexation plays a pivotal role in taxation when it comes to debt mutual fund investments. You may wonder what indexation is. In simple terms, it considers the rate of inflation when you calculate your returns on investments. Indexation results in a significant impact on your actual returns earned when you exit your investments in debt funds. Through indexation, your investment price is adjusted for inflation for the purpose of determining your tax liability when you exit. Indexation offers you several benefits because of the inflation adjustment.

Benefit of indexation

The indexed cost of your investment in debt mutual funds is based on the ratio of the inflation index at the time when you exit your investment. Therefore, a higher value means a reduction in your tax liability. During the long-term, the rising inflation adds up to the purchase cost of your debt funds. On a cumulative basis, it may result in the reduction of your taxable returns when you redeem your investment.

In case of smaller returns over a longer period, your entire returns on investments may be eaten up due to rising inflation. It is likely that in such a situation, you may not have to pay any taxes. It is beneficial because if most of your returns are erased due to inflation, paying taxes is not logical. Furthermore, the returns are only notional and not real due to the rising inflation.

Working of indexation

Indexation takes into account the date on which you invested your funds and the rate of inflation since then. When you apply the indexation benefit, your purchase cost increases. As a result, your profits at the time of exit reduce thereby reducing your tax liability.

Indexation and debt funds

Mutual fund investments are liable either to short-term or long-term capital gains tax. When you opt for tax-saving investments, long-term is defined as at least three years. Therefore, when you stay invested for at least three years, you will be liable to pay long-term capital gains tax. The current applicable rate is 20% post-indexation benefit.

For applicability of indexation, the formula is:

Original investment cost X Cost of Inflation Index (CII) at the time of exit/CII at the time of purchase

Let us understand this further with an example.

Assume that you invested INR 20,000 in tax-saving investments in May 2010. Further, assume that you redeemed your investment in June 2013 to earn INR 40,000. Therefore, your long-term capital gains before indexation are INR 20,000. However, your entire returns are not liable to tax because you remained invested for a period exceeding three years. You are allowed to avail of the indexation benefit, which reduces your long-term capital gains tax.

The indexed returns will be (20000*220)/167, which is equal to INR 26347 (CII was 167 in 2010-11and 220 in 2013-14).

Therefore, your taxable profits = 40000 – 26347 = INR 13653, which is a reduction of INR 6347 (20000 – 13653).

Until recently, the indexation base year was 1981, which is now modified to 2001. Therefore, if you invested before April 1, 1981, your profits may be calculated based on 1981 fair value. However, all investments after April 1 2017 will use 2001 as the base year to calculate the fair value.

In addition to earning profits, investments aim to determine how to save tax. One way is to use the indexation benefits on your long-term investments. You may also choose to pay taxes without taking the indexation benefit at a pre-specified tax rate.

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