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Most of us look at a multitude of parameters before investing, such as safety of capital, returns and l i q u i d i t y. However, we tend to ignore the reality of inflation. As prices for goods and services rise over a period of time, the value of one's investment decreases.
For instance, if the average inflation rate over the holding period of an investment is 6%, then investment returns must necessarily be above 6% to generate positive inflation adjusted returns.
In a high-growth and high-inflation economy like India, debt instruments are most affected by inflation as their returns are generally range-bound — between 8% and 10%.
Indexation is an option available for investors to manage their inflation-adjusted returns. It is a provision in the Indian Income Tax Act that allows investors to use inflation as a tool to reduce their tax liability from income generated through debt mutual funds and bonds.
The indexation benefit applies if such investments are held for more than 12 months. The same does not apply to bank fixed deposits and other small savings where the interest earned is taxed as per the applicable marginal tax slabs of 10%, 20% and 30%.
How does indexation work?
Let us take the example of a debt mutual fund with a holding period of greater than 12 months. The tax applicable is called long-term capital gains tax, where indexation benefits are applicable. Under the provisions, the purchase price of the investment is inflated to include the inflation rate over the holding period.
This reduces the effective taxable capital gains component, thus lowering tax outgo. Investors have a choice of either using or not using this indexation benefit, wherein the tax is calculated at 20% using indexation and at 10% without using indexation. The method which gives a lower tax outgo is ultimately chosen.
The inflation over the holding period of the investment is calculated using a government-notified factor, called the cost inflation index. The index uses 1981-82 as the base year where the value of the index is 100. This index is disclosed after the end of every financial year.
New Direct Taxes Code (DTC)
According to the new DTC proposed to be implemented by April 1, 2012 (if ratified by the Parliament), indexation benefits would continue but the tax rates would be modified to the marginal rates of 10%, 20% and 30% as applicable instead of 10% without indexation and 20% with indexation now.
Further, an investment needs to be held for one complete financial year to qualify for long-term capital gains and/or indexation benefits.
Thus, an investment which may be held for 13 months, say from January 2012 to February 2013, will not qualify for indexation due to this reason.
However, an investment held from March 2012 till April 2013 will qualify. Capital gains post indexation would be taxed at 10%, 20% and 30%, based on one's income tax slabs.
However, clarity is awaited on whether DTC would be applicable to prospective investments or whether retrospective investments would also be covered (wherein the end date is covered under DTC but not the starting date).
AN EXAMPLE OF INDEXATION
An investment of Rs 1,00,000 in a debt mutual fund in the financial year (FY) 2007-08 and sold at Rs 1,40,000 in FY 2010-11 would result in a capital gains of Rs 40,000 and a long-term capital gains tax of Rs 4,120 @ 10.30% (including 3% cess), without using indexation. If we consider indexation using cost inflation index of 551 in 2007 and 711 in 2011, the inflated purchase price would be Rs 1,00,000 X (711/551) = Rs 1,29,038.
Hence, capital gains post indexation would be lower at Rs 10,962 (Rs 1,40,000 less Rs 1,29,038). Long-term capital gains tax with indexation would thus be Rs 2,258 (20.60% of Rs 10,962, including 3% cess). Thus, the investor saves Rs 1,862 (Rs 4,120 less Rs 2,258) by using the indexation benefit.
Here, the average inflation over the four-year period according to the cost inflation index is 6.58%. However, if the inflation rate was lower at, say, 4% over this period, it would be beneficial to avail capital gains tax @ 10.30% without indexation. Thus, indexation benefits are useful where inflation has been high during the investment period.
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