All you wanted to know about indexation

K Venkatasubramanian | Updated on March 19, 2018

Stock market investors want it, but the finance minister isn’t keen to grant it. No, we aren’t referring to the part of a book that lists out the chapters with their relevant page numbers. Under the Indian Income Tax Act, indexation is a legitimate method to inflate your cost of purchase of real estate, debt funds, certain unlisted bonds and gold, so you pay lower taxes on gains when you sell these assets. While imposing long-term capital gains tax on equity investments in the recent Budget, the FM did not add on indexation benefits.

What is it?

We all know that a rupee today is worth more than what it would be worth a few years down the line. In other words, inflation eats into the value of the rupee and shrinks its purchasing power. Thus, when you make any long-term investment, your primary purpose is to earn a return over and above the inflation rate. This is why Indian tax laws allow the indexation benefit when you make gains from selling capital assets. Basically, your cost of buying the asset is adjusted for inflation when computing the gains.

Every year, the Central Board of Direct Taxes brings out the cost of inflation index (CII) applicable for the financial year. Based on the CII in the year of your sale, and that of your purchase, an indexation multiple is calculated for adjusting your purchase price. So, if the CII in the year of your purchase is 100 and that during your sale is 264, you can multiply your cost price by 2.64. You can then calculate your gains based on the indexed price of acquisition and pay tax.

If you bought debt funds for ₹1 lakh and sold them for ₹3 lakh, from the above example, your cost of acquisition would be ₹2.64 lakh. The effective gains would only be ₹36,000 (and not ₹2 lakh), on which you need to pay tax. The base year for the CII is 2001. All gains made before April 1, 2001 are calculated based on the fair market value as on this date. Remember, indexation is applicable only on long-term capital gains made on certain investments. ‘Long term’ varies for different asset types. It is 2 years for house/property and 3 years for debt mutual funds.

Why is it important?

In a capital-starved economy like India, it is important to induce people to save and invest. Indexation shields savers from bearing a heavy burden of taxes when they invest in any asset for the long-term. Indexation also drives home the point that it is ‘real returns’ from any investment that really matter. Let us assume that you make a 10 per cent annual return on an investment. If the inflation rate during your holding period is 6 per cent, your ‘real returns’ would only be 4 per cent, which effectively means that you would be earning a lot less than what’s on paper. It is only logical, therefore, that as an investor you be allowed to adjust your acquisition cost to inflation. During periods of high inflation and low capital appreciation, the indexation rule even allows you to book a capital loss, if your real returns are negative.

Why should I care?

As an investor, you need to compare different instruments on a post-tax return basis. So, when comparing instruments without indexation (bank deposits or equity mutual funds) with instruments with indexation (gold or debt mutual funds), you have to adjust your computations accordingly. On decisions to sell your ancestral property, family gold or debt or global mutual fund units you must remember that long-term capital gains are calculated after factoring in indexation.

The bottomline

You must pay taxes on gains made, but the portion eaten away by inflation must be shielded.

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Published on March 19, 2018

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