How inflation indexation impacts your tax pay-outs

If you are a mutual fund investor and invest majorly in debt-oriented funds, then the concept of indexation is quite important for you. Indexation has major impact on your returns from the investment as tax benefits at the time of exit are linked to it directly. 
  
Indexation is nothing but the process of calculating the tax liabilities on returns or profits earned from the investment. Indexation takes inflation into account while calculating the value of tax payable with respect to the investment. It adjusts your value of investment according to the inflation index. Most of the times, investors are expected to benefit from indexation. 
  
Indexation considers the year in which the investment is made as the base year, and from that year onward, it considers the inflation. So, using this, an investor can increase the purchase price of the fund and thereby reduce the profit and returns on the investment, thereby reducing his tax liability. 
  
The long term holding period for debt funds is defined as 3 years and more. These funds are subject to short and long-term capital gain taxation. The tax rate for long term capital gain is 20% after indexation. 

To determine the cost after indexation of investment or acquisition, it is important to be aware of the CII, which is the cost inflation index. This index is notified by the Central government every year. In recent times, it has been announced that the base rate to calculate the CII will be 2001. 

The indexed cost of acquisition is calculated by multiplying the original cost of acquisition with the product of CII of the year of sale divided by the CII of the year of purchase. So the formula is:

Original cost of acquisition x (Cost of Inflation Index (CII) of year of sale/CII of year of purchase) 



For example, an investor invested Rs.1 lakh in a debt fund in May 2011-12 and in 2014-15 he sold it at Rs.1.4 lakh. Hence, his profit was Rs 40,000, which is taxable. However, as his holding period was more than 3 years, he is eligible to use indexation to determine the inflation-adjusted profits at the end. 

So, as per the formula mentioned above: 
  
1 lakh * (240/184) = Rs 1,30,435 

With this, the indexed purchased price for the fund is arrived at Rs 1,30,345, so the profit from the fund liable for long term capital gain tax will be Rs 9,565.  (1,40,000-1,30,345). In this way, the indexation helps investors to get the real value of their investment and profit with reference to relative inflation and reduces the tax pay-outs.