Indexation and its benefits to Debt funds

By Nikhil Shah
With every financial year ending, your big task would be to calculate tax on income from sell of any asset you own (Real Estate, Shares, Mutual Fund, Gold, Debentures, Bonds). Tax applicable on any income from asset comes under head of capital gain. How Indexation works plays important role hear and its beneficial through Debt Mutual Fund let’s understand.
Concept of Indexation and role of CII Cost Inflation Index on capital gains tax calculation:

The value of rupee today will not stay the same for tomorrow. The prices keep increasing due to inflation. It is fair to pay more for toothbrush, restaurant bill, clothes etc. over the years because of the price rise due to Inflation. Likewise, it is not fair to pay Capital Gain Tax without incorporating the factor of inflation.
The government charges tax on our sale of the asset and they do not wish to let go of the capital gain. Hence, the government charges capital gains tax, which is calculated on the basis of CII.
Cost inflation index (CII) is an index issued by the Central Board of Direct Taxes and the figures keep changing every financial year.
In order to avoid paying a large sum towards tax, the sale price of the asset can be indexed to demonstrate the asset’s value as per its current value, taking into account inflation reducing its value. In this manner, the profit derived from the sale would be lower, thus reducing the capital gains payable.
Thus, indexation helps reflect the actual value of the asset at present market rates, taking into account the erosion of value due to inflation.
The CII for a particular year is fixed by the government and released every Fincancial Year(FY), for the purpose of tax computation.

Below is latest applicable CII (Cost of Inflation Index) chart:

The formula to calculate the cost inflation index is as follows:
Cost Inflation Index (CII) = CII for the year the asset was transferred or sold / CII for the year the asset was acquired or bought

Lets understand with practical case of with Fixed deposit Vs Debt Mutual Fund.

Mr. Parikh pro saving person comes under 30% tax slab.
He has done 2 Investments on same date and exited from them on same date.

Investment 1.

He invested in Bank Fixed Deposit Rs.1 Cr. at annual rate 8%, in Jan 2014. He exited from it for Rs. 1.24 Cr. in Jan 2017.

Computing tax for this investment is as below:
The Interest income = Exit value of Fixed Deposit – invested value of Fixed Deposit.
i.e., 1,00,00,000 – 1,24,00,000 = Rs. 24,00,000

His Net Interest income is Rs.24 lakhs in absolute term.

Tax liability is charged at 30% tax slab. The tax liability will be 24,00,000 X 30% = Rs. 7,20,000
Net Income in hand = Rs. 16,80,000  i.e., 24,00,000 – 7,20,000.

Investment 2.

He invested in Debt Mutual Fund Rs.1 Cr. at annual rate 8%, in Jan 2014. He exited from it for Rs. 1.24 Cr. in Jan 2017.

Computing tax for this investment is as below:
First we have to calculate CII by this formula.

Cost Inflation Index (CII) = CII for the year the asset was transferred or sold / CII for the year the asset was acquired or bought

The CII for the Jan 2014 FY in which Debt Mutual Fund was 220. The CII for the Jan 2017 FY mutual fund redeemed was 264.

The Cost Inflation Index (CII) is 264/220 = 1.20

While computing tax, CII is multiplied with the purchase price to arrive at the indexed cost of acquisition. This is the actual cost of the asset.
Therefore, the indexed cost of acquisition = 1,00,00,000 X 1.20 = Rs. 1,20,00,000

The long term capital gain= sale value of the asset – indexed cost of acquisition
i.e., 1,24,00,000 – 1,20,00,000 = Rs. 4,00,000

Tax liability by indexation method charged at 20%. The tax liability will be 4,00,000 X 20% = Rs 80,000

Below table will help you to understand it more clearly.

* In both Investments tax calculation surcharge and Education Cess is not considered. 
When you index, it helps you save taxes. It helps you adjust the purchasing price of the Debt Mutual Fund with the current market prices.

What is capital gain?
When you sell any asset you own (Real Estate, Shares, Mutual Fund, Gold, Debentures, Bonds are treated as assets) and you make a profit on the sale, it is known as capital gain. The tax you pay on profit earned is called as capital gains tax.
No tax if you make a loss (you sell at a lower price than you bought it), you incur a capital loss.

What are the types of capital gains on Debt Mutual Funds ?
Depending on how long you held the Debt Fund, the capital gain is classified either as short-term or long-term.

Note: In above case provided investment is in Debt Mutual Fund – Growth Option. In case of dividend option of Debt Mutual fund, Dividend Distribution Tax will be applicable as per given rate by govt. We will cover Dividend Distribution Tax in separate blog.

Short-term capital gain: Applicable if you sell the Debt Mutual Fund within 36 months from the date of purchase.
In traditional products such as fixed deposits or debentures, the interest on your investment is taxed as per your slab rate; that is –whichever tax slab you fall under. With debt mutual funds too, your gains (short-term gains) are taxed as per your slab rate if you held them for less than 3 years or 36 months.

Long-term capital gain: If you sell the Debt Mutual Fund after 36 months from the date of purchase.
After crossing 3 Years or 36 months in Debt Funds, method of tax calculation as per Indexation is game changer. And in traditional products it remains same as per tax slab of individual.

Income earned on traditional products is treated as Interest income under Head of Income from other sources.
However Income earned on Debt mutual fund is treated as capital gain under Head of Income from capital gain (Mutual funds are treated as Assets).

In above comparison table you can see how Mr. Parikh got benefited higher net income by paying low tax through the route of Debt Mutual Funds compared with low return by paying higher tax on Fixed Deposit.