What is Indexation? How can one avail benefits when it comes to Mutual Funds?

Amended as on Apr 1, 2023: Please note that as per amendments in Finance Bill 2023, from April 1, 2023, profits made on investments in debt mutual funds are now taxed as short-term capital gains if these funds invest <=35% in equities. This means, debt mutual funds are now taxed as per the income tax rates as per an individual’s income.

Also note that with effect from Apr 1, 2020, Dividend Distribution Tax (DDT) was abolished, and mutual fund dividends were made taxable in the hands of investors. Dividend income is now considered as ‘income from other sources’ and investors need to pay tax on it as per their individual tax slabs.

This article is currently in the process of getting updated, as it was originally written at a time when tax rules were different. Please treat this note as the latest updated tax information in the meanwhile.

Mutual fund schemes that invest at least 65 per cent of their assets in Indian shares and related instruments are classified as equity oriented schemes and the others as debt oriented schemes. Indexation is a concept applicable to the taxation of debt oriented schemes. Here’s more on it.

Taxation of debt funds

If your holding period of debt schemes is at least 3 years, the gains qualify as Long Term Capital Gains (LTCG) and are taxed at 20 per cent after applying indexation (explained later). But if your holding period is less than 3 years, your gains would be classified as Short Term Capital Gains (STCG) which would simply be added to your total taxable income and taxed at the applicable slab rate.

Concept of indexation

You are aware that inflation is the phenomenon of rise in prices of goods and services over time. In other words, what Rs 100 could get you a year ago will be more than what it can get you today; similarly, what it gets you today will be more than what it will get you next year, and so on. This means that money is losing value continually. This impacts your investments too. Let’s understand this with an example. Let’s say you invested Rs 10,000 three years ago. After 3 years, you plan to sell the investment. When you compute the profits (capital gains) you have earned from the investment, if you simply subtract your sale value from your investment cost, you would be ignoring inflation; in other words, the profits you earn from an investment includes the inflation amount on your investment cost. The government does not want to tax investors on the inflation value of your profits; hence the income tax department provides a Cost Inflation Index (CII) table every financial year which increases the cost of your investment to the extent of inflation. It is pertinent to note that the same CII number will be applicable for any day of a particular financial year. So whether your transaction is on 1st April (the first day of the financial year) or 31st March (the last day of the financial year) or any intermittent day of the financial year, the same CII number is applicable.

How indexation applies to capital gains on debt funds

Indexation is applicable to the LTCG on debt mutual funds. You can index your purchase Net Asset Value (NAV) before calculating the taxable index gain as illustrated below:

Date of investment 1-10-2011 (FY 2011-12)
Amount invested Rs 1,00,000
NAV of scheme on date of investment Rs 11.46
No. of units purchased 8,726
Date on which the investment was sold 09-10-2015 (FY 2015-16)
NAV of scheme on date of sale Rs 20.63
Amount realized on sale Rs 1,80,000
Gain on investment Rs 80,000
CII for 2011-12 785
CII for 2015-16 1081
Indexed cost of acquisition of unit Rs 15.78 (1081/785)*11.46
Capital gain liable to tax Rs 42,321 (20.63-15.78)*8726
Tax on the above gain Rs 8,718 20% of Rs 42,321 + Education cess of 3% on the tax amount

Here, though the actual investment gain is Rs 80,000, because of indexation of the original investment, only Rs 42,321 is being taxed. The balance amount of Rs 37,676 is simply the effect of inflation on your original investment and hence, no tax is applicable on this.

Conclusion: Indexation is a tool that you can utilize to reduce your LTCG liability on debt mutual fund investments. Debt fund returns that you would realize would hence be attractive due to this lower tax incidence.

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Key Takeaways

  • Mutual fund schemes are broadly classified as debt and equity oriented depending on their equity exposure.
  • Debt mutual fund schemes qualify for LTCG if held for a minimum of 3 years.
  • Indexation is the adjustment of your original capital for the effect of inflation during your investment period.
  • Due to indexation, debt funds offer better tax adjusted returns.