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How inflation cuts your tax
April, 07th 2014

From the finance minister to the humble peon in his office, everyone is worried about high inflation. Well, almost everyone. For some investors, high inflation can also be a boon that brings down their tax on long-term capital gains. Long-term capital gains are eligible for the indexation benefit, which can reduce the tax to almost nil.

Indexation is a useful tool for investors like Pankaj Gulati. The Delhi-based engineer is socking away money in debt funds for his retirement. "With the current high inflation, the capital gains from debt-oriented mutual funds after inflation indexation are virtually taxfree ," he says. We calculated the effective tax rate on an investment of 1 lakh in a debt fund in 2003-4. Assuming an annual return of 9% on the investment and an annual withdrawal of 9,000 after one year, the average effective tax rate after indexation has been less than 3% in the past 10 years.

How can the tax be so low on systematic withdrawal plans (SWPs)? First, when the investor withdraws from his investment, a large portion of the redemption amount is the principal. The gains constitute only a small portion in the initial years. In the first year, for instance, less than 9% of the redeemed amount is the gain. What's more, indexation pushes up the price of acquisition and brings down the capital gains even further to barely 1%.

Though the capital gains component and tax liability will keep on increasing over the years under the SWP, it will remain competitive compared to other fixed income options such as bank FDs. The treatment of income as capital gains is what helps debt funds score over fixed deposits. The income from fixed deposits is fully taxable as income of the investor and taxed at the normal rate. If he is in the 30% tax bracket (taxable income of more than 10 lakh a year), the post-tax yield on a 9% fixed deposit is only 6.3%. As our calculation shows, the post-tax yield from the debt fund will be close to 8.74% if the investor claims the indexation benefit. If he doesn't go for indexation and pays a flat 10% tax, the yield will be lower at 8.1%.

The indexation approach is particularly useful if you buy at the fag end of the financial year. If 1 lakh was invested in March 2009 in a debt fund that gave 9% annualised returns, the investment would have been worth 1.53 lakh in March 2014, but the indexed cost would be 1.61 lakh. So you would have booked a loss of 8,000 when you redeemed the investment. But if you redeemed the investment in April, it would have been more beneficial. The CII for the financial year 2014-15 will only be announced later in the year. If we assume it to be 9% higher at 1,023, the indexed cost will be higher at 1.75 lakh and you will be able to book a loss of almost 22,000.

This is why around March the market was flooded with FMPs that extended into the first few days of financial years in the future. Many of them were for 13 months, which will get double indexation benefits. Double indexation can be availed of if the holding period is across three financial years. If you bought a 380-day FMP in March, it would have matured in April 2015. Even with a reasonable indexation benefit of 8% per year, the double indexation would have taken the indexed cost up by 16.64%, much higher than the potential return from the FMP. The gains would not only be tax-free but you could even book a loss. "You can set off this loss against other long-term capital gains," says Sandeep Shanbhag, director of Wonderland Consultants.

Keep in mind that not all investments are eligible for the indexation benefit. It is specifically denied to any instrument that mentions an interest rate. So, even though debentures or bonds are listed and traded in the market and the profit from their sale is treated as capital gains, there is no indexation benefit available. This bar is applicable even for the bonds where the interest is compounded over the years. "The rule is simple. Indexation benefit is not allowed if the rate of interest per annum is mentioned anywhere," says Viren Pandya, a Mumbai-based chartered accountant.

This rule is designed to stop investors from getting multiple benefits. Otherwise, a tax-free bond will give tax-free interest every year and also allow the investor to book a huge long-term capital loss after 10-15 years. It is not clear how the new inflation-indexed bonds, where only a small real interest is paid out every year and the inflation part is added back to the principal, will be treated. "We need to wait and watch as there is no clarity on the issue," says Shanbhag.

The proposed Direct Taxes Code will drastically change the way capital gains are calculated. While there will be no distinction between short-term and long-term capital gains, the holding period will be calculated from the end of the financial year in which the assets were acquired.

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