Indexation is one of the more complex concepts in the world of mutual fund Capital Gains taxation.

Let’s quickly go through the other easier to understand mutual fund Capital gains taxation clauses –

How equity mutual funds are taxed?

The taxation treatment of equity mutual fund capital gains is fairly straightforward.

The inflection point at which short term becomes long term for equity is 1 year.

All the equity mutual fund gains that are less than 1 year old are termed short term capital gains.

All the equity mutual fund gains that are more than 1 year old are termed long term capital gains.

Short term capital gains for equity mutual funds is 15%.

Let’s say you invest Rs. 10,000 in equity fund A. Unfortunately, the value of your investment becomes Rs. 9,500 after 6 months and you panic and redeem your investment.

There are no capital gains and hence no tax applicable. Rather your capital loss can set off up to Rs. 500 of short term capital gains that you probably made on some other fund(s).

However, let’s now assume, instead of Rs. 9,500, the value of your investment after 6 months is Rs. 11,000 and you choose to redeem your investment completely again.

In this case, the short term capital gains is Rs. 1,000 and will be taxed at 15%. So you will have to pay a tax of Rs. 150.

Long term capital gains beyond Rs. 1,00,000 (exemption per FY) is 10%

Let’s say you invest Rs. 1,00,000 in equity fund A again.

After a couple of years, the value of the investment becomes Rs. 2,00,000 and you choose to redeem your investment completely.

The long term capital gains that you have booked are Rs. 1,00,000.

But despite these gains, you will not have to pay any tax! (assuming there are no other long term capital gains from other equity and related instruments)

This is because long term capital gains, in case of equity mutual funds, are exempted for the first Rs. 1,00,000 of gains!

But if your investment value was Rs. 2,50,000 after a couple of years, you would have made Rs. 1,50,000 worth of capital gains on your equity mutual fund investments.

Again, the first Rs. 1,00,000 will be exempted but the incremental Rs. 50,000 will have tax applicable at 10%!

So, in this case, you pay Rs. 5,000 (10% of Rs. 50,000) as long term capital gains tax.

Taxation on equity mutual fund is pretty straightforward, isn’t it?

How debt mutual fund are taxed?

Change number 1: The inflection point at which short term becomes long term is 3 years.

Change number 2: The short-term capital gains are taxed at your marginal tax rate. The short-term capital gains are considered as additional income and you are taxed accordingly.

Change number 3: The long-term capital gains are taxed at flat 20% with the benefit of indexation.

What is indexation?

Indexation simply means ‘adjusted for inflation.’

Think about the value of Rs. 100 in the year 1990, 2000, 2010, 2019!

The value of Rs. 100 has progressively decreased and will continue to decrease due the phenomenon of inflation – a steady increase in prices of goods and services.

This means if you have made capital gains of Rs. 100 over 5 years as Rs. 20 over each year. And let’s assume that every year the inflation was 5%.

While this isn’t how indexation works, we are simply trying to understand what exactly indexation will do. (we have even excluded the idea of short-term capital gains for now to keep it simple)

As you can see, if you make Rs. 20 every year for 5 years, in today’s value, although it would amount to Rs. 100, the actual value would be considerably lesser at Rs. 86.5. We have assumed an inflation of 5%!

Now that we know what indexation seeks to do, let’s now see how you can work out the applicable long-term capital gains on debt mutual fund after accounting for indexation.

The CII (Cost Inflation Index) which also conveys inflation is supposed to be used. Here are the CII values over the years…

Let’s get down to the calculation!

Let’s say you make an investment of Rs. 1,00,000 in 2012 in a debt mutual fund. Additionally, you fully redeemed the investment in 2017 – let’s say the value of the investment in 2017 was Rs. 2,00,000.

So, in nominal terms (not adjusted for inflation) the long-term capital gains that you have accrued is Rs. 1,00,000. Let’s see how this changes when indexation is applied.

Here are the important data points –

• Investment Amount – Rs. 1,00,000
• Investment Year – 2012
• CII in 2012 – 200
• Redemption Amount – Rs. 2,00,000
• Redemption Year – 2017
• CII in 2017 – 272

The question that needs to be answered is – What is the value of Rs. 1,00,000 (the investment amount) in 2017 (redemption year)?

It is intuitive and calculated as follows –

Indexed Cost = Rs. 1,00,000 * (272/200) = Rs. 1,36,000

Now, this is our indexed cost. This will be considered as the invested amount for the purpose of this calculation.

This implies that the long-term capital gains is Rs. 2,00,000 – Rs. 1,36,000 (Redemption amount – Indexed Cost) = Rs. 64,000

This amount attracts 20% long term capital gains tax which comes out to be Rs. 12,800.

Without the benefit of indexation, the long-term capital gains tax would have been 20% of Rs. 2,00,000 – Rs. 1,00,000 which comes out to be Rs. 20,000.

In Conclusion

Indexation is simply adjustment for inflation in the economy.

Indexation considerably helps lower the long-term capital gains on debt mutual funds.

Between two instruments with similar yields (think of fixed deposits and debt mutual funds), the post-tax returns of the instrument which allows for benefit of indexation will be higher given a positive inflation environment.

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