All that you should be aware of Indexation benefit

As per the tax structure of our country, an investor gets the benefit of indexation on the long term gains from debt mutual funds 

Given below are the details of indexation on mutual funds in India.

What is Indexation? – definition and explanation

Indexation is the benefit of inflation adjustment that is provided to the investors when they have held their debt funds for a long term. When an investor redeems his long-term debt mutual funds (held for more than 3 years), the capital gain is adjusted to incorporate inflation which is referred to as indexation benefit. Indexation helps an investor reduce their tax liability by increasing the purchase price on account of inflation.

By the way, this benefit is available to many other asset classes like real estate, gold, stocks and shares of a listed or an unlisted company, etc. 

How does Indexation work?

Inflation eventually reduces the value of money over time.

Let us take an example of a fund having NAV of Rs.100 today and it increases to Rs. 150 after 5 years. The investor has received a capital gain of Rs. 50 in this case over a period of 5 years. If the fund is a debt fund, then the investor will get the benefit of indexation on the long term capital gains. 

Indexation is calculated on the basis of a Cost of Inflation Index (CII). This is a number notified by the Ministry of Finance for each financial year. Investors can get this number from the Ministry website or from the website of Income Tax Department of India.

The formula for Long term capital gains based on indexation is given below.

Long-term Capital Gain = Selling Price of an Asset – Indexed Cost of an Asset

Indexed Cost of an Asset = Purchase Price of an Asset x (CII in the year of sale/ CII in the year of purchase)

(Where CII = Inflation Index for the year in which the asset was sold)

Let us consider an example to better understand the benefit of indexation to an investor.

An investor has invested Rs. 50,000 each in a debt funds Fund A March 2018. The investor redeems Fund A at Rs. 75,000 after 3 years in March 2021. 

Having debt funds, the investor will get the benefit of indexation on fund B. The tax incidence on such funds with and without the benefit of indexation is explained below.

Particulars Fund A (Without Indexation) Fund A (With Indexation)
Initial Investment  Rs. 50,000 Rs. 50,000
Period of holding 3 years 3 years
Benefit of Indexation Not Available  Available 
Cost of Inflation Index Not applicable 301
Indexed value of Investment Not applicable 55331
Sale/redemption Value Rs. 75,000 Rs.75,000
Long term capital gains Rs. 25,000 Rs. 19,669
LTCG @ 20% Rs. 5,000 Rs. 3934

With the above example, we can see that indexation benefit provides a tax savings of Rs.1066 in long term capital gains on debt funds on account of increased purchase price.

Benefits of Indexation

As discussed above, indexation helps the investor in saving tax liability. The benefit of indexation is only available on the debt funds and not on equity oriented funds. Investors can also get the benefit of indexation on hybrid debt oriented funds as they are taxed in line with debt mutual funds. 

Some benefits of indexation are mentioned below. 

  • Reduction in taxability of the funds on account of increased purchase price or initial investment
  • Provides an added advantage to debt funds over equity oriented funds

Taxation on Mutual Funds

Debt mutual funds mainly benefit from indexation. For your ready reference, here is the tax structure on various categories of mutual funds.

Type of funds Short term gains Tax rate Long term gains Tax rate
Equity mutual funds Less than 12 months 15% (plus cess and surcharge) 12 months and more Exempt up to Rs.1,00,000Above Rs.1,00,000 taxed at 10% (plus cess and surcharge)
Debt mutual funds Less than 36 months Slab rate of investor 36 months and more 20% (plus cess and surcharge)
Hybrid equity oriented mutual funds Less than 12 months 15% (plus cess and surcharge) 12 months and more Exempt up to Rs.1,00,000Above Rs.1,00,000 taxed at 10% (plus cess and surcharge)
Hybrid debt oriented mutual funds Less than 36 months Slab rate of investor 36 months and more 20% (plus cess and surcharge)

In case of hybrid mutual funds, if a fund holds more than 65% of its assets in debt, then it is categorised and taxed as a debt mutual fund. 

Conclusion

Mutual funds have been a preferred investment destination for millions of investors in India. The tax benefits on the investment play a crucial factor that influences the investment decision of any person. The indexation benefit on the debt oriented mutual funds provides the investors with an added advantage over similar investment options. Investors have to, therefore, choose the investment option carefully keeping in mind their investment goals and the post tax returns that can be availed on the mutual funds.

FAQs

1. What are the types of mutual funds based on asset classification?
Mutual funds are broadly classified under three broad categories as per asset classification. These categories are,

  • Equity oriented mutual funds
  • Debt oriented mutual funds
  • Hybrid mutual funds 

2. Is the benefit of indexation available on equity oriented mutual funds?
No. Equity oriented mutual funds do not get the benefit of indexation on long term gains.

3. Where can an investor find the CII?
CII is the cost of the inflation index that is notified by the government for every financial year. This number is available on the website of the Finance Ministry and the Income Tax Department.

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