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# Chapter 15 What is Indexation?

Inflation is a term that most of us are familiar with. It is the general rise in the price levels and makes life more expensive, and therefore, more difficult. According to the Consumer Price Inflation (CPI) numbers put by the Ministry of Statistics and Program Implementation (MOSPI) each month, the current rate of inflation is around 5% per annum. It means the cost of living will go up to that extend approximately. Here is how the cost of living will look like for next 5 years.

### Illustration 1:

Monthly Expense Today At the end of Year 1 At the end of Year 2 At the end of Year 3 At the end of Year 4 At the end of Year 5
Rs.10,000 Rs.10,500 Rs.11,025 Rs.11,576 Rs.12,155 Rs.12,763

Inflation reduces the value of money. From the above table, we can infer that if you are spending Rs.10,000 each month now, then you need to spend at least Rs.12,763 each month after 5 years to maintain the same standard of living. That is because costs are going up. You can also look at this in another way. If someone is committing to pay you Rs.10,000 at the end of 5 years, then that is just worth Rs.7,738 in today’s value. That is called the time value of money and is determined by the rate of inflation, which indirectly determines the rate of interest.

Why the rate of inflation is relevant when it comes to investments?

You may wonder as to why this rate of inflation is so important when it comes to investing. Let us consider an illustration.

### Illustration 2:

Manish has invested Rs.10,000 in a debt mutual fund which gives him 8% returns each year on an average. Since it is a growth fund, there is no dividend paid out in between. Effectively, at 7% annualized returns, the investment grows to become Rs.14,026 at the end of 5 years. However, Manish has a tax challenge here. Since he has held the debt fund for more than 3 years, it will be considered as long-term capital gain (LTCG). Now, Manish has a capital gain of Rs.4,026 (Rs.14,026 – Rs.10,000). So should he pay tax on Rs.4,026? The answer is no! While Manish has earned returns of 7% annualized, part of that returns are eaten away by inflation. For example, if you consider the table in Illustration 1, then the inflated cost at the end of 5 years is Rs.12,763. That means instead Manish’s effective taxable capital gains should not be Rs4,026 but only Rs.1,263 (14,026 – 12,763). That actually looks fair to Manish as he can now pay lower tax. That is exactly how the Income Tax Act also taxes capital gains net of inflation. It is just that the Income Tax Act approaches this issue slightly differently so as to standardize the entire process. For that, let us understand the concept of Cost Inflation Index (CII).

Cost Inflation Index (CII) and how to rework capital gains

CII is a technique to reduce tax payments by employing a price index which adjusts for inflation. In other words, indexation is the process that takes inflation into account from the time you bought the asset to the time you sold it. The purchase date and the sale date are considered as the two data points for the purpose of indexation. The way it works is that it allows you to inflate the purchase price of the asset to take the impact of inflation into account. The end result is that you get the benefit of lowering your tax liability. Inflation erodes the value of an asset over time, as we explained earlier, and so, the tax department gives you a benefit of reducing your capital gains for tax purposes by inflating your cost of acquisition in line with inflation.

There is a practical problem here. If the Income Tax Department were to allow individuals to apply the rate of inflation, then different individuals would apply different rates of inflation. For example, somebody may apply June inflation and somebody may apply May inflation; similarly, somebody may apply rural inflation while others may apply urban inflation, and so on, The need of the hour is to standardize the entire process and that is what the Income Tax Department does through the announcement of annual index numbers for the purpose of tax calculation. Check the table on index numbers below:

Index Values announced by Income Tax Department (Base is 2001-12)
FY 2001-02 FY 2002-03 FY 2003-04 FY 2004-05 FY 2005-06 FY 2006-07
100 105 109 113 117 122
FY 2007-08 FY 2008-09 FY 2009-10 FY 2010-11 FY 2011-12 FY 2012-13
129 137 148 167 184 200
FY 2013-14 FY 2014-15 FY 2015-16 FY 2016-17 FY 2017-18 FY 2018-19
220 240 254 264 272 280

These numbers above are the guide that all individuals paying capital gains must use for indexing in the corresponding year. When you buy in a particular year and sell in another, you must multiply the original cost of acquisition by the selling year index number and divide by the buying year index number. The result will be the indexed cost of acquisition which will be higher than the original cost of acquisition. You only need to pay capital gains tax on the indexed value of capital gains, which is the difference between the selling value and the indexed cost of acquisition. Let us see how this works.

### Illustration 3:

If you purchase an asset in September 2010 for Rs.64 lakh and sell it for Rs.127 lakh in September 2017, then here is how your capital gains will be calculated purposes.

Particulars Amount Indexation Amount
Cost of Purchase Rs.64 lakh Actual Capital Gain Rs.63 lakh
Month of Purchase Sept 2010 Indexed Cost of Buy
{63* (272/167)
Fiscal Year FY2010-11 Rs.103 lakh
Sale Value Rs.127 lakh Sale Value Rs.127 lakh
Month of Sale Sept 2017 Indexed Capital Gain Rs.24 lakhs
Fiscal Year FY2017-18 Taxed at 20% Rs.4.80 lakh

In the above illustration, the taxable capital gains come down from Rs.63 lakh to Rs.24 lakh, and hence, the tax paid is just Rs.4.80 lakh. The effective tax paid on LTCG on the sale of house property, therefore, works out to just 7.6% (4.80 lakh/63 lakh). This is the benefit that indexation proffers to the investor when calculating the tax on capital gains.

Indexation with specific focus on debt funds

Indexation is a prudent way to prevent the draining of your debt fund returns by way of taxes. It helps you inflate the purchase price of the fund. This way, you can lower your tax liability. When it comes to debt funds, it is important for you to understand two concepts i.e. inflation and capital gains.

Let us revise our concept of capital gains briefly before getting down to calculating it in the case of debt fund investments.

Capital gains refer to an increase in the value of an investment over a specific time frame. If the NAV of the debt fund at the time of purchase was Rs.45 and after 5 years you sell the debt fund units at Rs.73, then the capital gains will be Rs.28 per unit. However, you don’t have to pay tax on the entire capital gains of Rs.28 but only on the indexed capital gains. We will understand this with an illustration.

Remember, in case of debt funds, the investor has two options. You can either choose to pay flat tax at 10% or you can pay 20% tax on indexed capital gains.

Which of the options should you choose? Let us look at this decision from the point of view of an investor who has booked long-term capital gains on debt funds. Remember, debt funds, being non-equity, are treated as long-term capital gains if held for a period of more than 3 years. Let us compare a 10% flat tax on capital gains on a debt fund with 20% tax with indexation and see if indexation really benefits the investor.

Gains from the sale of debt mutual fund units are classified as capital gains that allow the investor to use indexation while computing tax on them. This is applicable on long-term capital gains on investments that have been held for 3 years and more.

### Illustration 4:

Let’s say you invested in a debt fund in May 2013. Your investment amount was ₹50,000 and you bought the units at an NAV of ₹10, giving you 5,000 units in total. Let us, for the purpose of simplicity, ignore the effect of other costs. In May 2018, you redeemed your 5,000 debt fund investments units in the debt fund at a NAV of ₹16 and realized Rs.80,000 in the process. Before we get into the tabular calculation, let us spend a minute with the concept of Indexed Cost of Acquisition for greater clarity.

In the above case, since your holding period is more than 3 years (5 years in this case), you will get the benefit of indexation to reduce the value of your long-term capital gains.

To arrive at the Indexed Cost of Acquisition (ICoA), you have to use the following formula:

ICoA = Original cost of acquisition*(CII of year of sale/CII of year of purchase)

Now let us tabulate the results of the above illustration in a table.

Particulars Paying 10% flat tax on LTCG Paying 20% taxed on Indexed gain
Cost of Acquisition of debt fund Rs.50,000 Rs.50,000
Value of redemption of units Rs.80,000 Rs.80,000
Actual Capital Gain Rs.30,000 Rs.30,000
CII in Year of Purchase N.A. 220
CII in Year of Sale N.A. 280
Flat tax on capital gains Rs.3,000 N.A.
Indexed Cost of Acquisition (ICOA) N.A. Rs.63,636
Indexed Capital Gain 16,364
20% tax on Capital Gains Rs.3,273

In the above illustration, the investor would be almost indifferent between indexing and paying 20% and not indexing and paying 10% flat tax. However, when inflation rates are much higher, the impact of indexation is felt and that is when the concept of indexation works to your benefit.

Understanding double indexation

A very important benefit that debt funds use quite often is the benefit of double indexation. Here is how it works. You enable the investor to buy the debt fund close to the end of the fiscal year and then redeem it after 3 years, a few days after April 01. Effectively, your holding period will be 3 years and a few days only, but then you will be getting the benefit of indexation for 4 years. Let us see how this works in practice.

### Illustration 5:

Jayant invested in a Fixed Maturity Plan (FMP) with HDFC Mutual Fund on March 29th 2015. This FMP was redeemed on April 03, 2018, by the fund. FMPs are closed-ended funds where the fund invests in securities whose maturity profile matches with the maturity profile of the fund. What happens in this case is that March 29, 2015, falls in FY2014-15, whereas the sale date of April 03, 2018, falls in FY2018-19. Effectively, the cost of acquisition in the case of Jayant will be indexed by the CCI of FY2018-19/CCI of FY2014-15. That gives him the benefit of 4 indexation years even though he holds it for just 3 years and 5 days. These kind of debt funds and FMPs are issued basically to give debt fund investors the additional benefit of double indexation.

Finally, equity funds do not offer indexation benefits

Till March 2018, equity funds did not attract any long-term capital gains (LTCG) tax in the hands of the investor. However, Budget 2018 introduced a flat tax rate of 10% on equity gains on mutual funds, where such gains were booked after April 01, 2018. This is only applicable to LTCG since STCG is still taxed at 15%. However, the budget also explicitly stated that the tax on equity funds LTCG will be flat, and therefore, shall not offer the benefit of indexation. This point needs to be remembered since the cost of indexation formula will not apply to LTCG on equity funds although you will have to pay tax on 10%.