#### Mutual Funds

| Updated on August 30, 2020

What is indexation? How is it calculated? What is its relevance for tax treatment of STCG/LTCG in mutual funds ?

AS Venkata Rao

The concept of indexation comes into play while calculating tax on long-term capital gains (LTCG) on the sale of certain assets such as debt mutual funds or house property. Indexation is useful for an investor as it helps reduce the tax on gains.

That’s because indexation increases the effective cost of acquisition of the asset and reduces the amount of capital gain on which tax has to be paid. Capital gain is, broadly speaking, the selling price of an asset minus its cost of acquisition.

Indexation takes into account the fact that the value of money generally reduces over time due to inflation. That is, if ₹100 could buy you five items of a commodity today, the same ₹100 might be able to get you only three items of the commodity after, say, two years.

Since the value of money reduces with time due to inflation, it might be unfair if the capital gain on sale of an asset is calculated as selling price minus its actual cost of acquisition, and tax is applied on this gain.

So, indexation allows the actual cost of acquisition to be increased — this reduces the capital gain and the tax on this gain.

Here’s an example. Say, you bought an asset in February 2015 (FY2014-2015) at ₹1,000, sold it in May 2020 (FY 2020-21) at ₹2,500 and the gains are taxed at 20 per cent. So, without indexation benefit, the capital gains will be ₹1,500 (₹2,500 minus ₹1,000), and the tax will be ₹300 (20 per cent of ₹1,500).

If indexation is allowed, the indexed cost of acquisition goes up to ₹1,254, the capital gains will be ₹1,246 (₹2,500 minus ₹1,254), and the tax will be ₹249 (20 per cent of ₹1,246). Ergo: indexation helps reduce the tax outgo on the capital gains.

The indexed cost of acquisition is determined by using the cost inflation index (CII) values provided by the government for each financial year (FY). For instance, the index value is 100 for the base year FY2001-2002; it is 240 for FY2014-15 and 301 for the ongoing FY2020-21.

The indexed cost of acquisition is the actual cost of acquisition multiplied by the index value in the year of sale divided by the index value in the year of purchase.

So, in the above example, the indexed cost of acquisition = ₹1,000 x 301/240 = ₹1,254.

If an asset has been purchased before the base year (2001-2002), the cost of acquisition can be taken as the actual purchase cost or the fair market value on April 1, 2001, whichever is higher, and then such cost can be indexed.

Now, as per tax laws, the benefit of indexation is available only on LTCG and not on short-term capital gains (STCG). Depending on the period of holding of an asset, the capital gain can be STCG or LTCG.

For instance, if a non-equity fund is held for more than 36 months before sale, the gain becomes LTCG, else it is STCG. In the case of equity funds, if the fund is held for more than 12 months before sale, the gain becomes LTCG, else it is STCG.

Non-equity-oriented funds include debt funds, gold funds, hybrid debt-oriented funds, international funds and fund of funds. Equity-oriented funds are those that invest above 65 per cent of their corpus in the equity shares of domestic Indian companies. This category includes include equity funds, equity-linked savings schemes (ELSS), hybrid equity-oriented funds and arbitrage funds.

Also, the indexation benefit is not allowed on all asset classes. For instance, the benefit of indexation is allowed on LTCG on non-equity-oriented MFs, but not on LTCG on equity-oriented funds.

So, on LTCG on non-equity funds, tax is levied at 20 per cent with indexation benefit.

STCG on non-equity funds are taxed at the investor’s tax slab rate without indexation benefit. Surcharge on tax, if any, and cess at 4 per cent on tax-plus-surcharge will apply.

LTCG of up to ₹1 lakh a year on equity-oriented funds is exempt from tax and the rest is taxed at 10 per cent without indexation benefit. STCG on equity-oriented funds is taxed at 15 per cent without indexation benefit.

Surcharge, depending on the income level, and cess at 4 per cent on tax-plus-surcharge will apply.

Indexation to compute LTCG is a fair principle, resulting in taxing only real, inflation-adjusted returns.

This principle also leaves open the prospect of long-term capital loss in the future, if inflation runs high. Such loss, too, can reduce tax liability by setting it off against gains, as per laid-down rules.

Besides cost of acquisition, the cost of improvement, if applicable, of the capital asset can also be indexed while computing LTCG.