Mutual fund indexation involves adjusting the purchase cost of a mutual fund investment to account for inflation. This process helps reduce the taxable gains, thereby lowering the overall tax liability on the investment. This adjustment aims to minimise the tax burden on investors. Explore further to grasp the intricacies of mutual fund indexation. Notably, significant alterations in taxation regulations were introduced by the Finance Act of 2023, effective from April 1st, 2023.
In this article, we will learn how to apply, calculate, and benefit from indexation. We will also learn the concept of cost indexation rates and see how indexation works, specifically in the context of mutual funds.
What is indexation in mutual funds?
Capital gains from mutual fund investments arise from the sale of underlying assets and are classified as short-term or long-term based on the holding period. Taxation varies by fund type, with debt mutual funds benefiting from indexation, which adjusts acquisition costs for inflation, thereby reducing taxable gains. For debt mutual funds, a holding period of 36 months or more qualifies as long-term, while equity mutual funds require 12 months or more for the same classification. Short-term capital gains from debt funds, held for less than 36 months, are taxed as per the investor's income tax slab.
Calculation of indexation
To calculate the adjusted purchase price of debt fund units for long-term capital gains purposes, the Cost of Inflation Index (CII) is applied. The CII, a value notified by the Ministry of Finance for each financial year, is used to adjust the original purchase price for inflation.
The adjusted purchase price is determined by dividing the CII of the year of sale by the CII of the year of purchase and multiplying the result by the original purchase price. This adjusted figure is then used to calculate long-term capital gains.
For example, if Mr. A purchased 5,000 units of a debt mutual fund at Rs. 18 per unit in the financial year 2012-13 and sold them at Rs. 27 per unit in the financial year 2018-19, the inflation-adjusted purchase price would be calculated as follows:
- Adjusted purchase price: (280/200)*18 = Rs. 25.20 per unit
The long-term capital gains on the transaction would then be:
- 5,000 units*(Rs. 27 - Rs. 25.20) = Rs. 9,000
Note: The CII values used in this example are illustrative and may differ based on the actual values published by the Ministry of Finance..
Indexation example
Let's consider an investment scenario where an individual purchases mutual fund units for Rs. 10,000 in the financial year 2018-2019. After three years, they decide to sell these units for Rs. 15,000 in the financial year 2021-2022. Now, without considering indexation, the entire capital gain of Rs. 5,000 would be subject to taxation.
However, if indexation is applied, the acquisition cost is adjusted to reflect the inflation rate over the holding period. Let's assume that the cost inflation index (CII) for the financial year 2018-2019 was 280, and for 2021-2022, it rose to 320.
Using the indexation formula:
Indexed Cost of Acquisition = Original Cost of Acquisition × (CII of Year of Sale / CII of Year of Purchase)
= Rs. 10,000 × (320 / 280)
= Rs. 11,428.57
Now, the indexed cost of acquisition is Rs. 11,428.57. Consequently, the capital gains are calculated as the difference between the selling price (Rs. 15,000) and the indexed cost of acquisition (Rs. 11,428.57), resulting in a taxable gain of Rs. 3,571.43.
By applying indexation, investors can reduce their tax liability significantly, thus optimising their returns from mutual fund investments.
Strategies of Indexation
Indexation, the practice of adjusting prices, wages, or other financial values to compensate for inflation or other changes in economic conditions, is a prevalent feature of contemporary economic systems. While it is widely adopted, the subject remains a source of debate among economists and policymakers.
From a microeconomic perspective, indexation offers several advantages. It facilitates contract negotiations between private parties, especially in environments characterized by high inflation. By maintaining relative prices, indexation helps mitigate the adverse effects of inflationary shocks on economic transactions. Wage indexation, for instance, can reduce the need for frequent wage negotiations and lower labour market transaction costs.
Moreover, indexation is often seen as a critical component in developing liquid long-term fixed-income markets, particularly in emerging economies. By linking the value of financial instruments to a relevant index, indexation can enhance their attractiveness to investors.
However, the macroeconomic implications of indexation are more complex. In some cases, indexation can contribute to macroeconomic stabilization efforts. By automatically adjusting prices and wages, it can help prevent inflationary expectations from spiraling out of control. On the other hand, excessive indexation can also exacerbate inflationary pressures, especially if it is not accompanied by appropriate monetary and fiscal policies.
Also read: Difference Between Assets and Liabilities
Significance of indexation in mutual funds
Indexation in mutual funds is a crucial mechanism for reducing the tax burden on long-term capital gains, particularly for debt mutual funds. It adjusts the acquisition cost of an investment to account for inflation over the holding period, effectively lowering the taxable gains. By reflecting inflationary changes, indexation ensures that investors are taxed only on real returns, not nominal gains.
This feature is especially significant for long-term investors in debt funds, as it can substantially minimise tax liability and enhance post-tax returns. For instance, if an investment is held for over 36 months, the indexed cost reduces the capital gains subject to tax, making it a tax-efficient option. By aligning taxation more closely with actual purchasing power, indexation promotes fairness and encourages long-term investing. This makes it an attractive feature for those seeking stable, inflation-adjusted returns from their investments.
Applying Indexation to Mutual Funds
When it comes to mutual funds, indexation plays a crucial role in determining the taxable gains on your investments. When you sell your mutual fund units, any profit you make is subject to capital gains tax. However, if you've held your investments for the long term, the gains might not be as substantial when adjusted for inflation. This is where indexation steps in to provide a fairer picture of your gains.
A duration of 36 months or beyond is categorised as the long term for debt funds. Any tenure less than 36 months for Debt funds is classified as short term, and the resulting gains are integrated into the investor's income for tax computation. (For equity mutual funds, long-term means a holding period of 12 months or more.)
Indexation benefit in mutual funds
Indexation in mutual funds offers a significant advantage by reducing the tax liability on capital gains. It achieves this by adjusting the purchase price of an investment to reflect inflation over the holding period. This adjustment ensures that only the real gains—those exceeding the effects of inflation—are subject to taxation, not the nominal gains.
For long-term investments, especially in debt mutual funds held for more than 36 months, indexation can be a powerful tool. It allows investors to reduce the taxable portion of their returns, which directly translates to a lower tax burden. By focusing on real gains, indexation ensures a fairer taxation approach, considering the erosion of purchasing power caused by inflation.
This tax-saving mechanism helps investors retain a larger share of their returns, making it an attractive feature for long-term financial planning. It encourages investment in debt funds by enhancing post-tax returns, aligning with the objectives of wealth preservation and growth. Indexation’s ability to account for inflation while calculating tax liability adds considerable value, promoting both fairness and efficiency in managing mutual fund investments.
Also read: What is dearness allowance
On which assets can you claim indexation benefits?
As per the income tax laws, indexation benefits can be claimed only on certain long-term capital assets. This means that long-term gains from the sale of these specified assets can qualify for indexation benefits. Read the table below to learn about capital assets eligible for indexation benefits:
Nature of asset |
Holding period |
Land and/ or buildings, Unlisted shares |
Held for more than 24 months before being sold |
Any other specified assets (e.g., Gold jewellery) |
Held for more than 36 months before being sold |
Specified debt mutual funds |
Held for more than 36 months before being sold |
How to calculate indexation in mutual fund?
The formula for calculating indexed cost is straightforward:
Indexed Cost = Actual cost or cost of purchase × (CII of the year of sale / CII of the year of purchase) |
Indexation involves adjusting the purchase price of an asset for inflation, facilitated by the Cost of Inflation Index (CII). This index, issued annually by the Finance Ministry and accessible on the Income Tax Website, aids in determining the adjusted cost of acquisition for Debt Fund units. To calculate this, divide the CII of the selling year by that of the acquisition year, then multiply by the actual purchase cost to derive the adjusted price, crucial for long term capital gains computation.
What is indexation rate or Cost Inflation Index (CII)?
Here, CII or the Cost Inflation Index, is a tool used to measure the changes in inflation over time. It is released by the government each financial year. Let us see the Cost Inflation Index table from the financial year 2010-11 to 2023-24:
Financial year |
Cost Inflation Index (CII) |
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 |
2019-20 |
289 |
2020-21 |
301 |
2021-22 |
317 |
2022-23 |
331 |
2023-24 |
348 |
Let us understand this with an example:
Imagine you invested in a mutual fund with an actual cost of Rs. 2,00,000 in the year 2015. The CII for that year was 254. You decide to sell the investment in 2023, when the CII has risen to 340.
Indexed Cost = 2,00,000 × (340/254) = Rs. 2,68,504
If you sell the investment for Rs. 3,50,000, your indexed capital gain will be:
Indexed Capital Gain = Selling Price - Indexed Cost
= 3,50,000 - 2,68,504
= Rs. 81,496
The tax payable on this indexed capital gain will be significantly lower on Rs. 81,496 as compared to the tax on the nominal gain of Rs. 1,50,000.
How does this work in debt mutual funds?
It is crucial to understand that starting from April 1, 2023, debt funds no longer offer indexation benefits, making all gains taxable at the slab rate. However, investments made in debt funds before this date retain the privilege of indexation for long-term capital gains.
Now, with the CII numbers for both the investment and redemption years, one can calculate the indexation benefit to minimize tax liability on long-term capital gains from debt funds. For instance, consider Rama, who invested Rs. 1 lakh in a debt mutual fund in August 2016 (FY 2016-17) and redeemed it for Rs. 1,50,000 in November 2020 (FY 2020-21). As the investment spanned over 3 years, categorising the gain as Long-Term Capital Gain (LTCG), indexation benefit applies, mitigating tax on the entire gain of Rs. 50,000. To ascertain the taxable gains post indexation benefit, the original purchase price is adjusted for inflation using CII.
The formula employed is: Inflation-Adjusted Purchase Price = Actual Purchase Price X (CII in the year of sale/CII in the year of purchase).
Tax rate on long term capital gains for debt funds
The tax rate for Long-Term Capital Gains (LTCG) on Debt Funds stands at 20%, which increases to 22.88% after factoring in a 10% surcharge and 4% education cess. This rate is notably favourable compared to taxes on other Fixed Income instruments such as bank Fixed Deposits.
For our example, the applicable tax amounts to 22.88% of Rs. 9,000, resulting in Rs. 2059, as opposed to Rs. 10296 (22.88% of Rs. 45000). Consequently, there is a significant savings of Rs. 8237 {Rs.10296 – Rs. 2059}.
Also read: Different types of investments
Should you invest in debt mutual funds even without the indexation benefit?
Debt mutual funds continue to be a favoured investment choice, particularly for risk-averse investors seeking short to medium-term returns. While the indexation benefit has been a significant tax advantage, these funds still offer substantial tax benefits compared to traditional savings instruments.
To align your investments with your specific financial objectives, consider consulting with a qualified investment advisor. They can assist in crafting a diversified mutual fund portfolio that effectively balances risk and return.
Conclusion
Inflation is an inevitable force that can erode the value of your investments over time. However, with the strategic use of indexation, mutual funds provide you with a mechanism to mitigate the impact of inflation on your investment returns. By accounting for inflation when calculating capital gains tax, indexation ensures that you are not unfairly taxed on gains that are merely compensating for rising prices. As you navigate the world of investments, harnessing the power of indexation can be a smart move to safeguard the real value of your investments and optimise your after-tax returns.
