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The primary goal of all types of investments is to grow your wealth by generating returns. However, factors like rising inflation and taxation rules of investments often adversely impact returns. One way in which, long-term investors can get tax relief to some extent is by taking the benefit of indexation. Read on to know the definition of indexation, how indexed returns of investments is calculated and it impacts the net returns from your investments.
What is Indexation?
Indexation can be defined as a method using which the price of an asset or investment is adjusted in order to factor in the impact of inflation. This adjustment is done mathematically using a cost index chart or indexation chart. Post the adjustment of purchase price via indexation, the taxable returns of the investment decrease, leading to a reduction in the tax liability accrued for the investment. This reduction in tax liability leads to higher net returns for the investor.
What is Indexation Chart and How to Use It?
The indexation chart or Cost Inflation Index (CII), is a metric used to calculate the annual increase in the price of products or assets due to inflation. The central government updates this cost inflation index chart on an annual basis to account for the annual rate of inflation. The government gazette then publishes the indexation chart. The Cost Inflation Index Chart is included in Section 48 of the Income Tax Act of India, 1961. Below is the CII chart applicable for FY 22-23 (AY 23-24) using the current base year FY 2001-02:
Financial Year |
Cost Inflation Index |
2001-02 |
100 |
2002-03 |
105 |
2003-04 |
109 |
2004-05 |
113 |
2005-06 |
117 |
2006-07 |
122 |
2007-08 |
129 |
2008-09 |
137 |
2009-10 |
148 |
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 |
As you can see from the above indexation chart, for the base year (currently FY 2001-02), the index set at 100. As a result of inflation, this index value increases with the passage of time. The data in the above chart can be used to calculate the indexed cost of an investment, which we will discuss next.
How to Calculate the Indexed Cost?
To get a clear understanding of how indexed cost of acquisition is calculated, let’s take a simple example. Suppose you purchase a plot of land in FY 2004-05 for Rs. 10 lakh and sell the plot in FY 2020-21 for Rs. 30 lakh. So the total profit you get from the transaction is Rs. 20 lakh.
However, you actually do not need to pay tax on the entire Rs. 20 lakh of gains due to the indexation benefit. To find the actual taxable returns, you can use the indexation chart and find the indexed cost of acquisition. So the formula is:
Indexed Cost of Acquisition = Actual Cost of Acquisition x (CII for year of sale / CII for year of purchase)
As per the indexation chart, the CII (Cost Inflation Index) for FY 2004-05 is 113 and CII for FY 2020-21 is 301. The indexed cost of acquisition in FY 2020-21 for the plot of land bought in FY 2004-05 will be:
Indexed Cost of Plot of land = (Rs. 10 lakh) x (301/113) = Rs. 26.64 lakh
So, net taxable profit after indexation = Rs. 30 lakh – Rs. 26.64 lakh = Rs. 3.36 lakh
So, the applicable rate of capital gains tax will be applicable on net profit of Rs. 3.36 instead of the total profit of Rs. 20 lakh. This will bring down your tax liability significantly resulting in higher net returns from your investment.
Benefits of Indexation
The primary benefit of indexation is that it helps investors determine the fair market value of their investment. By factoring in inflation and rising cost of acquisition of the investment, the investor is able to reduce the tax liability resulting from long-term capital gains. Under current indexation rules, only certain long-term capital gains such as property can be used to avail the benefit of indexation.
Earlier debt mutual funds and debt-oriented hybrid funds also featured the benefit of indexation on long term gains if scheme units were held for 3 years or longer prior to redemption. As of April 1, 2023, debt-oriented mutual fund schemes no longer feature the benefit of indexation. However, any debt fund units purchased on or before 31 March, 2023 will continue to benefit from indexation provided they are held for 3 years or longer prior to redemption.
Strategies of Indexation
Many markets and economies have widespread indexation regulations and procedures. Most of the time, price adjustment clauses in private contracts result from widespread inflation. When it comes to matters of public debt, taxation, public tariff settings, and other institutional arrangements, governments occasionally play a significant role in pushing the use of indexation.
Although indexation-related techniques are standard in most modern economies, there is still considerable disagreement over this subject. On the one hand, indexation facilitates economic agreements and contracts between private agents under high and even under moderate inflation from a microeconomic point of view. The system of relative prices can withstand significant inflation shocks in particular thanks to indexation.
Indexing wages and other financial benefits is an excellent example of a plan that achieves this goal. In nations where inflation is at least moderate, wage indexation eliminates the need for regular wage negotiations and may lead to lower labour market transaction costs.
Additionally, the success of building liquid long-term fixed-income markets may depend on indexing financial instruments, as evidenced by the experience of various emerging economies. However, indexation also affects the macroeconomic environment. In many stabilization measures, indexation has in particular, been crucial.
How Does Indexation Work for Debt Funds?
The idea of indexation makes investing in debt mutual funds profitable since it gives investors a chance to obtain post-tax returns that are marginally higher. This is because indexation, by employing the Cost of Inflation Index, considerably reduces capital gains and can be used as a way to save income tax.
Higher inflation rates raise the acquisition cost (buy price) of units, which lowers taxable profits and, as a result, reduces capital gains tax. This reduces the tax burden, in turn. Here is the short-term capital gains (STCG) and long-term capital gains (LTCG) tax rules for various types of mutual funds for your quick reference.
Type of Mutual Fund |
Short Term Gains Holding Period |
STCG Rate |
Long Term Gains Holding Period |
LTCG Rate |
Equity Mutual Funds |
1 year or less |
15% on capital gains |
Over 1 year |
10% on capital gains exceeding 1 lakh for the applicable FY |
Debt Mutual Funds |
3 years or less |
As per income tax slab of the investor |
Over 3 years |
As per income tax slab for units bought after 31st March 2023 / 20% with indexation for units purchased on or before 31st March 2023 |
Hybrid Equity-oriented Funds (equity allocation of 65% or greater) |
1 year or less |
15% on capital gains |
Over 1 year |
10% on capital gains exceeding 1 lakh for the applicable FY |
Hybrid Debt-oriented Funds (debt allocation of 65% or greater) |
3 years or less |
As per income tax slab of the investor |
Over 3 years |
As per income tax slab for units bought after 31st March 2023 / 20% with indexation for units purchased on or before 31st March 2023 |
A hybrid mutual fund is classified and taxed as a debt mutual fund if more than 65% of its assets are held in debt. Also as per Budget 2023 announcement, there is no longer any indexation benefit of long-term investment in debt mutual funds. Both LTCG and STCG gains of debt mutual funds and debt-oriented hybrid are now taxed as per the income tax slab rate of the investor for the applicable financial year. Similarly, equity-oriented hybrid funds have minimum equity allocation of 65% and are taxed the same as equity mutual funds and other equity schemes.
Conclusion
The ability to gain from indexation had earlier led many investors to stay invested in debt-oriented mutual funds for the long-term i.e. that is 3 years or longer. Now that this benefit is no longer available, some investors are expected to start to moving away from these mutual fund schemes and opt for other long-term debt-oriented investments like bonds, public provident fund, fixed deposits and recurring deposits. However, the benefit of indexation is still applicable on real estate investments even though its derivatives like Real Estate Investment Trusts (REITs) do not offer the benefit of indexation.
Frequently Asked Questions (FAQs)
Q1. When is indexation advantage not permitted?
A variety of investments including but not limited to various types of mutual funds, and debt oriented investments like certificate of deposits (CDs), treasury bills (T-Bills), etc. do not offer the benefit of indexation.
Q2. Can indexation be negative?
Theoretically, it might be possible to have negative indexation if a country has a long-term period of negative inflation i.e. deflation. However, as of yet, long-term deflation has not occurred in India, so negative indexation has not occurred.
Q3. Are equity-oriented mutual funds eligible to receive the advantage of indexation?
No. Mutual funds that focus on investing primarily in equities do not benefit from indexation on either short or long-term returns.
Q4. Where can investors find the CII chart?
During each fiscal year, the government publishes cost of the inflation or CII chart. The websites of the Income Tax Department and the Finance Ministry both provide access to this data.
Q5. How is a property's cost inflation index determined?
The indexed cost is determined using the following formula:
Indexed Cost of Acquisition = Original Acquisition Cost X (CII for the year of sale/CII for the year of acquisition).
Sources:
https://wealthbucket.in/blog/indexation
https://zfunds.in/m/cost-inflation-index
https://cleartax.in/s/indexation-helps-reduce-tax-debt-fund-gains
https://www.investopedia.com/terms/i/indexation.asp
https://www.moneycontrol.com/news/business/personal-finance/explained-all-about-debt-fund-taxation-and-indexation-6618151.html
https://especia.co.in/cost-inflation-index/
ARN No : July23/Bg/20A