Through indexation, your cost of investment is adjusted to inflation while calculating your tax.

If you are considering investing in debt mutual funds, you would definitely come across the term ‘indexation’ and its impact on your investment. Indexation has a major impact on your returns from debt fund investments since tax benefits at the time of exit are linked to it.

So, what is indexation? Quite simply, It is the process that takes inflation into account at the time of calculating taxes. Through indexation, your cost of investment is adjusted to inflation to calculate your tax. Investors most often stand to gain due to the adjustment.

Indexation considers the year when an asset was bought and the inflation since then. Using indexation, you can increase the purchase price of your debt fund units so as to reduce your profit and hence, the tax on it. This is how indexation benefits long-term investments in debt funds.

For debt mutual funds, the long-term holding period is defined as 3 years and more. Mutual funds are subject to short-term and long-term capital gains tax. When a debt fund investment is held for over 3 years, the gains made on the investment would be subject to long-term capital gains tax. This would be at the rate of 20% after indexation.

Archit Gupta, Founder, and CEO, ClearTax.com explains with an example:

Let’s say you invested in a debt mutual fund in May 2010. Your investment amount was Rs10,000 and you bought the units at a NAV of Rs 10. Three years later, in June 2013, you redeemed your investments when the unit NAV was Rs 20. Hence, when you sold your investments, the value of your investments was Rs 20,000. Out of this, your gains will be Rs10,000. However, you will not have to pay tax on this entire amount of Rs 10,000. Since you held the investments for 3 years, you will be allowed to use indexation to reduce the value of your long-term capital gains.

To apply indexation and arrive at the indexed cost of acquisition, here’s how you can calculate it using following formula:

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

In the above example, this will be 10,000 x 939/711 = 13,207. Hence, instead of Rs 10,000, your gains will be Rs 20,000 – Rs 13,207 = Rs 6,793. Using indexation, you managed to not pay tax on nearly Rs3200 of your gains. Your tax will be computed on only Rs 6,793, which will come to Rs 1,359 at 20% long-term capital gains tax.

One can check the CII (cost of inflation index) below:
SI. No. Financial Year (FY) Cost of Inflation Index
1 2001-02 100
2 2002-03 105
3 2003-04 109
4 2004-05 113
5 2005-06 117
6 2006-07 122
7 2007-08 129
8 2008-09 137
9 2009-10 148
10 2010-11 167
11 2011-12 184
12 2012-13 200
13 2013-14 220
14 2014-15 240
15 2015-16 254
16 2016-17 264
17 2017-18 272
In the announcement made in the recent budget, the new base rate to calculate CII will now start from 2001, prior to which till March 31, 2017, the capital gain was calculated with 1981 as the base year.

This means that the purchase price of a debt fund or a property bought before April 1, 1981, can be calculated on the basis of the fair market value of 1981. Similarly, from April 1, 2017, onwards, the purchase price will be calculated based on the fair market value of 2001.

Therefore from now onwards, capital gains on debt fund or assets acquired before April 1, 2001, will be calculated using fair market value as mentioned in the year 2001.