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Indexation: A Guide on the Meaning, Benefits, and Calculation

Q: On which assets is indexation applicable?

Long-term investments, such as debt funds and other asset classes, are eligible for indexation. Indexation facilitates the process of modifying the initial investment cost. You will be able to reduce your tax obligation in this way.

Calculating the gain or loss on your investments is mostly dependent on indexation. By modifying the acquisition price of the underlying item or investment, indexation will lower your overall tax liability. Since you may adjust your gains for inflation in the years of purchase and sale, you can realise bigger returns. The indexation benefit on long-term capital gains has been withdrawn by the government as of July 23, 2024. This implies that investors will no longer be able to factor inflation into the acquisition price of their investments when determining their capital gains for taxation. The government has, however, offered taxpayers the choice to apply either 12.5% without indexation or 20% with indexation on real estate transactions that were completed before July 23, 2024. We will go through the details of indexation in this article.

Table of Content

What is Indexation?

Benefits of Indexation

Strategies of Indexation

Calculation of Capital Gains on Mutual Funds with Indexation

Indexation in Debt Funds

Cost Inflation Index Value (CII)

Cost Inflation Index and Capital Gain

Conclusion

Most Asked Questions

What is Indexation?

Indexation is one successful way to avoid having your investment profits eaten up by taxes. Debt funds and other asset classes are among the long-term assets subject to indexation. Indexation facilitates the process of modifying the initial investment cost. This will allow us to reduce tax obligations. Gaining an understanding of inflation and capital gains is essential before considering indexation. A steadily rising cost of goods or services is known as inflation. For instance, a hundred rupees today can be worth a hundred and twenty-one the next year, and even more the year after. Inflation diminishes the value of money in this way. It implies that a person can purchase fewer items annually for the same amount as he can now. Inflation will drive up the price of goods and services.

Benefits of Indexation

Using indexation, one can modify an investment's purchase price to account for the impact of inflation. Less profit means a higher buying price, translating into a smaller tax.

Reduced long-term capital gains will result in a lower taxable income for you thanks to indexation. Comparing debt funds to traditional fixed deposits (FDs), one of the best options for fixed-income investments is because of indexation.

Investing becomes a win-win situation owing to indexation. The Cost Inflation Index (CII) provided by the government can be used to determine the inflation rate for indexation. The index's values are set by the Central Government and are maintained on the website of the income tax department. You can view the Cost Inflation Index from 1981 onwards.

Strategies of Indexation

Regulations and processes about indexation are common in many markets and economies. Adjustments to price clauses in private contracts are typically a result of overall inflation. Governments periodically exert a considerable amount of influence in favour of indexation when it comes to issues of public debt, taxation, public tariff sets, and other institutional arrangements. Even though most modern economies use indexation-related strategies, there is still a lot of debate on the topic.

From a microeconomic perspective, indexation, on the one hand, makes economic agreements and contracts between private agents easier to execute in the face of high and even moderate inflation. Indexation also allows the relative price system to withstand large inflation due to indexation.

One great way to accomplish this is by indexing wages and other financial benefits. Salary indexation removes the need for recurring salary negotiations in countries with at least modest inflation and may result in cheaper labour market transaction costs. As multiple emerging economies have shown, indexing financial instruments may also be necessary for the successful development of liquid long-term fixed-income markets. However, the macroeconomic climate is also impacted by indexation. Indexation has proven very important in several stabilisation strategies.

Calculation of Capital Gains on Mutual Funds with Indexation

An investment's increase in value over a given period is referred to as a capital gain. Capital gains are when the value of your investment increases. For example, if the NAV of a debt fund was Rs. 10 last year and now Rs. 15, you have made a profit. In this case, the capital gain on your investment upon redemption would be Rs. 5 per unit.

A capital gain is the difference between an investment's buying and selling prices. Debt funds are considered long-term investments, held for more than 36 months, and capital gains are calculated by indexing the investment's initial purchase price.

After the Budget 2024, the holding period for debt mutual funds eligible as a long-term asset has been reduced from 36 months to 24 months. Continuous capital gains on debt funds are taxable at a 20% rate with indexation, unlike equity funds. Consider that stock funds are exempt from indexation. On the other hand, long-term capital gains on debt securities are subject to a 12.5% tax with no indexation starting on July 23, 2024.

Indexation in Debt Funds

Assume that in July 2019, you invested in a debt fund. At a net asset value (NAV) of Rs. 10, you purchased the units with an investment of Rs. 10,000. In August 2022, after three years, you redeem your assets at a net asset value of Rs. 20. The value of your investments was Rs. 20,000 when you sold them. Rs. 10,000 in capital gains were generated by your investment. You don't need to pay tax on the entire Rs 10,000 sum. Since you held the asset for three years, indexation will work in your favor to lower the long-term capital gains value. Utilising the following formula, you must get the Indexed Cost of Acquisition (ICoA):

ICoA is equal to the initial cost of acquisition * (years of buying and selling CII).

The acquisition cost that is indexed will be equal to Rs. 10,947, or 10,000 * 289/264. Your capital gains will now be Rs.9,053, or (Rs.20,000 – Rs.10,947), rather than Rs. 10,000.

Your tax will be calculated at a 20% rate on just Rs. 9,053, or Rs. 1,810. A prolonged holding period enhances the benefit of indexation. Tax on long-term capital gains on debt funds can be reduced from 20% to 6-7% for a holding period of five years. Indexation works to improve your earnings and reduce your tax on long-term capital gains from debt mutual funds.

For instance, in the fiscal year 2012–13, Mr. A bought 5000 units of the debt mutual fund XYZ for Rs. 18, and in the fiscal year 2018–19, he sold these units for Rs. 27. (This transaction is eligible for indexation benefit since the units were held for longer than 36 months.)

The transaction's profit is as follows: 5000 (27-18) = Rs 45000

Initially, we determine the purchase price adjusted for inflation:

Inflation-adjusted Purchase price: (280 /200)*18 =25.2

The LTCG for the transaction is calculated as follows:

5000 x (Rs. 27- Rs. 25.2) = Rs. 9000

Cost Inflation Index Value (CII)

We can compute long-term capital gains from asset sales using the cost of inflation index. The inflation rate utilised for indexation is derived from the government's cost inflation index (CII). Each year, the central government determines the index value, which is then updated on the Income Tax Department website.

Cost Inflation Index and Capital Gain

Over time, inflation tends to increase. Therefore, it makes sense to consider the same while attempting to construct an index cost for capital gains and estimating one's tax due. The most common method to track inflation is through the Cost Inflation Index (CII). The latest Cost inflation index produced by the Government of India is employed to calculate the long-term capital gain index. The capital gain index cost computation is aided by it.

To figure out the long-term capital gains, people need to determine the asset's indexed cost. The cost inflation index chosen for the financial year (the year the transfer is made) must be multiplied by the intended seller's property's acquisition cost. The resulting numerical value needs to be divided by the CII number assigned to the purchase year.

Illustration:

Mr. X purchased a home for Rs. 30 lakh on August 7, 2004, and sold it for Rs. 85 lakh on April 6, 2018. The following would be the indexed cost of acquisition:

(The acquisition cost multiplied by CII at sale)/CII at acquisition

(30 Lakh x 280) / 113 = 74.33 Lakh

In turn, Rs. (85 – 74.33) Lakh = Rs. 10.67 Lakh would be the capital gain.

The increase in capital index cost can be evaluated with the help of the Cost Inflation Index table provided below. In addition, it will help analyse the fluctuation in the rate of inflation that has controlled our economy for over ten years.

Financial Year	Cost Inflation Index (CII)
2001-02 (Base year)	100
2002-03	105
2003-04	109
2004-05	113
2005-06	117
2006-07	122
2007-08	129
2008-09	137
2009-10	148
2010-11	167
2011-12	184
2012-13	200
2013-14	220
2014-15	240
2015-16	254
2016-17	264
2017-18	272
2018-19	280
2019-20	289
2020-21	301
2021-22	317
2022-23	331
2023-24	348

Conclusion

Many investors used to stick with debt-oriented mutual funds for three years or more because they may benefit from indexation. Some of them are anticipated to begin leaving these mutual fund schemes now that this benefit is no longer available in favour of other long-term debt-oriented investments such as bonds, public provident funds, fixed deposits, and recurring deposits. The benefit of indexation, however, also applies to real estate investments even when its derivatives, such as Real Estate Investment Trusts (REITs), do not provide it.

FAQ

Q1. What is Indexation?

The primary goal of indexation is to modify the initial cost of an investment so that it accounts for inflation. It is primarily used to calculate the total gains or losses on investments.

Q2. What is the indexed cost of acquisition?

The assessee receives an indexed cost of acquisition as a benefit from gains on long-term capital assets. The cost is adjusted for inflation through indexing, which raises the value and lowers the capital gain tax.

Q3. What is the indexation benefit as per income tax?

The indexation benefit enables a taxpayer to pre-sell an asset and modify the purchase price by inflation. As a result, the seller's tax on long-term capital gains is reduced. Take an example where you bought an asset for Rs 100 around ten years ago; presently, its inflation-adjusted price is Rs 160.

Q4. Who is eligible for indexation benefits?

Debentures and bonds are not eligible for indexation advantages. A few exceptions are there; the Reserve Bank of India (RBI) provides sovereign gold bonds and capital indexation bonds that are entitled to indexation benefits. It implies that you can lower your taxable gains by adjusting their cost for inflation.

Q5. On which assets is indexation applicable?

Long-term investments, such as debt funds and other asset classes, are eligible for indexation. Indexation facilitates the process of modifying the initial investment cost. You will be able to reduce your tax obligation in this way.

Q6. On which assets is indexation not applicable?

Indexation does not apply to equity funds.

Q7. Is indexation allowed on depreciable assets?

Depreciable assets are categorised into blocks based on their rate of depreciation, which decreases their value over time. The formula for calculating capital gains differs according to transfers within or across whole asset blocks. Profit or loss is viewed as transient. Long-term assets no longer profit from indexation.

Q8. Can CII be used to reduce tax?

The cost of inflation index, or CII, can help you prevent paying a substantial amount of income tax on profits made from the sale of long-term capital assets.

Q9. How to calculate capital gain with indexation?

Long-term capital gains (LTCG) chargeable to tax is calculated as follows: LTCG chargeable to tax = Net selling consideration - (Indexed cost of purchase + Indexed cost of improvement) - Section 54/54B/54D/54EC/54F exemptions.

Q10. What is long-term capital gain without indexation?

Selling property that has been owned for longer than 24 months results in a long-term capital gain. As previously stated, the rates after indexation benefit for transfers done on or before July 22, 2024, will be 20%. The tax rate on subsequent transfers will be 12.5% minus the indexation advantage.

Q11. Do debt funds have indexation benefits?

Capital gains are calculated by indexing the investment's purchase price, and this process will continue until July 23, 2024, in the case of debt funds—long-term investments. Continued investment gains on debt funds are index-benefited and subject to a 20% tax rate. On July 23, 2024, however, long-term capital gains on debt funds would be subject to 12.5% tax with no indexation advantage as a result of the adjustments made in Budget 2024.