Indexation – Basic Concept and its Benefits

When it comes to investment the prime idea is to generate returns. However the issue is when we focus on these returns, we generally assume the return on paper to be our actual returns, ignoring the effect of taxation. Whereas in reality, it is the post-tax returns that really should matter. (In our Blog – How to Measure Returns? Part 1 and 2, we have explained the concept in Detail). What makes predicting or even calculating the post-tax return difficult is the different rules and rates for different avenues. One such rule (or benefit) that actually helps in reducing your tax outgo is Indexation. In this blog, we will look at Indexation, how it works, and how it helps you bring down the taxes you pay on your debt mutual fund investments. While Indexation is applicable and useful to those investing in debt mutual funds – we have always advised the new comers to make goal based investment. And debt mutual funds are an important part of it.

Inflation – Silent Killer

In Investment it is stated that – Inflation is a silent killer. Inflation in simple terms means, the things are going to cost us higher tomorrow than what we are paying today. And this is applicable to most of the things (with few exceptions where technology is bringing down the cost significantly). Or we can take it other way as well the value of money that we enjoy today will get lowered tomorrow. While the inflation is reducing the purchasing power in future, it also affects the returns generated through our investments. Just imagine if your investments have generated 8 percent per annum and the inflation stand at 3 percent. This means the net returns generated less than what it looks at superficial levels. Add to that the taxation impact and the returns are further lower. While in case of equity mutual funds and hybrid mutual funds the returns are usually on the higher side (naturally the risk is also higher). However when it comes to debt oriented funds the returns are just marginally higher than the risk free returns. In such cases the inflation cost plays a vital role. And hence the idea of indexation is an important part to understand. While we have already discussed the initial part indexation in our blog of taxation of Mutual Funds, let’s discuss it in detail.

Understanding Basics of Indexation?

In simple terms Indexation is defined as adjusting the purchase price of mutual funds investment to reflect the impact of inflation. As we mentioned earlier as the inflation impact reduces the net returns generated and the impact of the same is significant in debt oriented mutual funds schemes. Hence to adjust the returns generated to the inflation levels would provide some solace to the investors at least
on the taxation front.  Here indexation comes to the rescue. 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. The benefit of Indexation is to help one regulate purchase price of the investment, applicable to long term investments, including debt funds.

How to Calculate Indexation or Indexed Cost of Investment?

As stated the purchase price of mutual funds investment to reflect the impact of inflation. And for that one must understand the concept of Cost Inflation index (CII). CII is calculated to match the prices to the inflation rate. In simple words, an increase in the inflation rate over time will lead to a rise in the prices. The Central Government specifies the CII by notifying in the official gazette. CII is a tool used in the calculation of an estimated yearly increase in an asset’s price as a result of inflation. Now 2001-02 is considered a base year.

CPI (t) = (C_t/C_0) * 100

CPI (t) – Consumer price index in current period

C_t – Cost of market basket in current period

C_0 – Cost of market basket in base period

Cost Inflation Index = 75 percent of the average rise in the Consumer Price Index* (urban) for the immediately preceding year.

Now as we understand the concept of calculating the Cost Inflation Index, Let’s understand how to calculate Indexation.

Indexation is calculated as follows:

Amount Invested (CII for year of year of Sale/CII for year of purchase)

CII – Cost Inflation Index (Released every year by income tax department)

The above calculation gives us an ‘Indexed Cost’ of investment.

How is Indexation Applied?

Rather than explaining theoretically, let’s take an example to understand it in detail. Suppose Mr. X purchased Debt Mutual Fund of 5000 units at Rs. 20 in the Financial Year 2015-16 and later sold it at Rs. 23 in the Financial Year 2018-2019. As the units were held for more than 36 months the same qualifies for indexation benefit. The initial investment was Rs 1,00,000 (Rs 20 * 5000 units)and the current value not stands at Rs 1,15,000 (Rs 23 * 5000 units). Here the profit made by him would be Rs 15,000. In a normal taxation the capital gains coming under taxation would be Rs 15,000. However if the same is calculated base on indexed cost the figures would be completely different.

Put in the formula mentioned for Indexation it is as follows

Indexed Cost of Purchase will be

Rs 100000 *(288/254)

= Rs 1,10,236.

This means the profitability would be Rs 1,15,000 – Rs 1,10,236 = Rs 4754.

If we calculate the taxations based on normal profit – it comes to Rs 15,000 *20 % = Rs 3,000. However if we take the indexed level profit the taxation would be – Rs 4,754 *20% = Rs 953.

Following table elaborates the same in detail

The indexed price arrived at is used to calculate the capital gains on which LTCG tax of 20 percent plus surcharge of 10 percent plus education cess of 4 percent applicable. There is a direct relation between the inflation level and the indexation benefits. In simple terms, if inflation has been high in the period between the purchase and sale of the investment, then the indexed cost of acquisition of the investment will go up. Eventually reducing the gains on which the taxation is applicable. One must understand that, Indexation adjustment of purchase price is done just for calculating the tax on capital gains. It does not mean that the actual gains or profit made will reduce.