Indexation

Indexation is the process by which purchase price of assets like Gold, Real Estate and Debt Mutual Funds are adjusted to reduce the impact of inflation, while calculating return from these investments. Inflation is the gradual increase in price levels of goods and services over time, without any real increase in the value of the goods and services. For instance, a chocolate bar costing ` 50 today may cost ` 60 next year, even though there is no change to the weight or quality of the chocolate bar. This increase in price level of the chocolate bar is an example of inflation.

Here we’ll explain indexation with respect to Debt Mutual Funds since indexation benefit is applicable to Debt Mutual Fund investments that are held for more than 3 years. When you sell your Debt Mutual Fund investment after 3 years, you have to pay a tax on long-term capital gain of 20% after indexation benefit. Capital gain is calculated as the difference in the purchase price and selling price of your investment.

Suppose, you had invested ` 100,000 in a debt scheme ABC at a NAV of ` 10 three years back in Aug. 2015. You received 10,000 units of scheme ABC in return for your investment. Let’s assume the current NAV of the scheme is ` 20 and you sell all the 10,000 units at this NAV in Sept. 2018. The capital gain in this case would be the difference between the NAV at which you sold and the NAV at which you had invested 3 years back, multiplied by the number of units being sold.

Your capital gain would be = 10,000 units * ` 10 (i.e. ` 20 – ` 10) = ` 100,000

Now you need to pay a 20% LTCG (Long-Term Capital Gains Tax) on all Debt Mutual Fund investments that are held for more than three years as per current regulations.

But when indexation is applied to your capital gain, it will adjust the purchase price of your investment upward, so that the purchase NAV of Aug. 2015 reflects the impact of inflation over the three-year period. When the purchase NAV is revised upwards, it reduces the overall capital gain and thus the tax applicable.

Inflation-adjusted cost price =  Actual cost price  X  CII of sale year

CII of purchase year

CII or Cost Inflation Index is a value published by the finance ministry that is used to measure inflation. CII for 2018-19 is 280 and CII for 2015-16 is 254.

Hence, the inflation adjusted cost of acquisition would be = 100,000* (280/254) = ` 110,236

Your Long-Term Capital Gain post indexation would be, the difference in sale price and inflation adjusted purchase price = ` 200,000 – ` 110,236 = ` 89,764

Hence, you’ll now pay 20% LTCG on ` 89,764 and not on ` 100,000.

Indexation results in lower tax payout for debt Mutual Fund investments unlike traditional fixed income products like bank FDs. Thus, debt funds are more tax efficient than investments offering similar returns.