Mutual Fund Unlocked: What is Indexation?

In his budget speech of 2018, finance minister re-introduced long-term capital gains tax (LTCG) at a rate of 10 per cent. This will apply to all the gains, arising from the sale of equity shares or mutual fund, exceeding Rs. 1 lakh, without allowing any indexation benefit. So, what is this indexation, and how does it work?

The reason why indexation is used is that normally purchasing power of money keeps on declining with every passing period, due to inflation. Inflation is a sustained rise in the price of a product or service. What has priced Rs. 10 today can cost you Rs. 15 or more next year. Therefore, if you would have purchased one unit of a product this year, next year you could buy only 0.67 times for that unit. Hence, the same amount of money buys a lesser number of units one-year later. Now you see how inflation impacts your purchasing power. So, how is this indexation comes to rescue?

Now before explaining indexation, capital gain need to be understood. It is increasing in the value of your investment in a period. For example, net asset value (NAV) of a scheme is Rs. 10 today and increases to Rs. 15 by next year, Rs. 5 is your capital gain.

Indexation is used to adjust the purchase price of a scheme for inflation, mainly for calculating the long-term capital gains tax. This is done so that the investors are taxed only on the capital gain over and above the price rise caused by inflation. The government uses Cost Inflation Index (CII), to measure the rate of inflation. With FY2001-02 as the base (CII=100), it was fixed at 272 for FY2017-18.

Example: How Indexation Works

Mutual Fund Scheme brought in 2009-10 (CII = 148) for Rs. 1 lakh. Asset sold in 2016-17 (CII = 264) for Rs. 2 lakh. To arrive at the indexed cost of acquisition you must do the following.

Take the CII for the year in which the asset is sold and divide it by the CII for the year in which it was bought. This would be 1.783. This is now multiplied by the cost of acquisition (Rs. l lakh x 1.783) to arrive at the indexed cost of acquisition (Rs. 1,78,378). Capital gains would now equal to the indexed price being subtracted from the selling price of the asset: Rs. 2,00,000-Rs 178078 = Rs. 21,621.

Therefore, you need to pay tax only on Rs. 21,621 instead of Rs. 1 lakh (2,00,000-1,00,000). You can benefit out of it you are liable to pay long-term capital gain tax with fixed income mutual fund, real estate, unlisted shares and gold not the normal equity shares.