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What is Indexation Benefit?

    Home Financial Investments What is Indexation Benefit?

    What is Indexation Benefit?

    By Rupanjali | Financial Investments | Comments are Closed | 15 July, 2022 | 0

    Whenever you buy an asset and sell it at a profit after some years at a higher price, you are required to pay capital gains tax on such profits. However, when the value of your investment goes up in the future, inflation too needs to be taken into consideration for the increase in price. Inflation, quite simply, is the general rise in the price of goods and services over time. Thus, in order to compute actual capital gains on your investment, you need to take into account indexation.

    Indexation is an important method of offsetting the effect of inflation on your investments to compensate for the general increase in the price and increase the purchasing price of your asset using a fixed point of reference. In India, the Cost Inflation Index (CII) is used to compute the inflation-adjusted purchase price of an asset.

    Indexation is extremely important at the time of calculating capital gains of various assets such as debt mutual funds, real estate, gold etc. The CII number for each financial year is notified by the ministry of finance each year. The CII number for Financial Year 2018-19 is 280.

    The CII numbers for various years is as under:

    Year CII
    2001-02 100
    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

     

    The formula to compute the inflation-adjusted purchase price of the asset is:
    (CII number of the sale year /CII number of the purchase year)* Purchase price

    Some of the important things to keep in mind at the time of computation of capital gains taking indexation into account are:

    • The CII number can only be used to calculate the purchase price of those assets where the indexation benefit is allowed. You can use indexation benefit for long-term capital gains tax on debt funds but not on equity funds as equity and equity-related mutual fund schemes do not enjoy indexation benefit.
    • Debt funds held for a period of more than 3 years are liable for long-term capital gains tax and indexation benefit. Gains arising for sale of debt funds before completion of a period of 3 years are added to your total taxable income and taxed as per your tax slab.
    • The CII number of the year of sale of the asset should be used for the computation of long-term capital gains.

    Image by katemangostar on Freepik

    Understand with examples

    Let us look at some of the examples to understand the computation of indexed cost of your investment.

    Suppose you invested Rs. 20 lakh in a debt mutual fund scheme in the August 2013 and sold it in the year May 2018 at Rs. 30 lakh. Your total gains are Rs. 10 lakh.

    However, your inflation-adjusted purchase price will be calculated as under:
    (280/220)* Rs 20 lakh = Rs 25.45 lakh

    Thus, the long-term capital gains for the purpose of taxation would be
    30 lakh- 25.45 lakh= 4.55 lakh.

    Similarly, in the case of Real Estate, suppose you purchase a house in July 2005 for Rs. 30 lakh and sold it for Rs. 70 lakh in May 2016. Your gain from the sale of the house is Rs.40 lakh.

    However, in order to compute the long-term capital gains we will take into account the inflation-adjusted purchase price calculated as under:
    (264/117)*Rs 30 lakh= Rs 67.69 lakh

    Thus, the long-term capital gains would be Rs 2.31 lakh (Rs 70 lakh-Rs 67.69 lakh). The tax of 20% on the same would only be Rs 46,200.

    However, if this gain was in equity investment, with no indexation benefit, the capital gain would tantamount to Rs 40 lakhs since there is no indexation benefit in equity investments. If the same was redeemed at one go, then 10% of Rs 39 lakhs, (Rs 40 lakhs – 1 lakh of exemption) i.e. Rs 3.9 lakhs of long-term capital gains would be taxed.

    CONCLUSION

    The indexation benefit is a useful technique to lower the long-term capital gains on your investments which in turn helps you lower your total tax liability on such investments.

     

    Featured Image Credits: Image by Drazen Zigic on Freepik

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