Indexation is a important tool that helps in lowering the tax liability on the capital gain on the investments in debt oriented mutual funds.
In India, debt mutual funds are taxed as per the provisions of the Income Tax Act, 1961. The taxation of debt mutual funds is based on the holding period of the investment. If the investment is held for less than 36 months, the gains are treated as short-term capital gains (STCG) and are taxed at the investor’s applicable marginal tax rate. If the investment is held for more than 36 months, the gains are treated as long-term capital gains (LTCG) and are taxed at 20% after indexation.
Indexation is a method of adjusting the cost of acquisition of an investment to account for inflation. The indexed cost of acquisition is calculated by multiplying the original cost of acquisition by the cost inflation index (CII) of the financial year in which the asset is sold, and dividing it by the CII of the financial year in which the asset was acquired. The CII is issued by the government and reflects the inflation rate for a particular financial year. For eg. The CII is reflected by number such as 320 for a financial year and 329 for next financial year.
Understanding the tax liability on capital gain with and without Indexation in debt mutual funds investment
By using the indexed cost of acquisition, the impact of inflation on the investment is taken into account, reducing the tax liability on the capital gains earned from the investment. For example, if an investor purchased a debt mutual fund for Rs. 1000,000 in January 2019 and sold it for Rs. 1500,000 in January 2023, the long-term capital gain would be Rs. 500,000.
In the case of above calculations, the tax liability shall be on the capital gain of Rs. 500,000. Assume tax rate on LTCG is 10%. The tax liability in this case is Rs. 500,000 x 10% = Rs. 50,000.
Continuing with the above investment example:
Original investment in debt mutual funds : Rs. 1000,000
CII for financial year 2019 was 310 and for financial year 2023 is 328
Cost of investment with indexation = Cost of original investment x (CCI in 2023 / CII in 2019)
= 1000,000 x (328/310)
= 1000,000 x 1.058
= Rs. 1058,064
With the indexation benefit the tax liability shall be calculated at Rs. 1500,000 – 1058,064 = Rs. 441,935. Assume tax rate on LTCG is 10%. The tax liability in this case is Rs. 500,000 x 10% = Rs. 44,194.
It is important to note that while indexation can help reduce the tax liability on debt mutual fund investments, it is a complex process and requires the calculation of the CII for each financial year. Investors should consult a tax professional to understand the implications of indexation and to ensure that they are taking advantage of this tax-saving opportunity.