Indexation For Capital Gains: Meaning, Calculation, And Tax Benefits

By: Tavaga Research

When considering making a long-term investment, out of a gamut of objectives investors have, probably the most pressing objective is to earn high returns. With such a laser focus on these returns, investors generally take the return on paper to be the actual return, completely ignoring the effect of taxation. In reality, it is the post-tax returns that should matter the most. 

However, predicting or calculating the post-tax return is an onerous task, given the different rules and rates that apply to different investment avenues. More importantly, taxes can chip away a significant proportion of the returns earned on the investments. 

This article focuses on a rule (or benefit) that actually helps you in reducing your tax outgo, known as indexation. It plays an important role in the calculations of gains and losses on your investments. 

What is indexation? – Indexation meaning

Indexation is a process that allows investors to adjust the cost of acquisition of an asset to account for inflation between the time that the asset was bought and sold. It is an efficient way to prevent the drain of your returns on investments in the form of taxation. Indexation is applicable to long-term investments that include debt funds, gold funds and international ETFs.

Indexation for capital gains

In other words, indexation is a technique that takes into account inflation from the time the asset was bought to the time it was sold. The way it works is that it allows you to inflate the cost of acquisition of the asset to account for the impact of inflation. Through this process, investors will be able to lower their tax liabilities. 

Before going into detail about indexation, it is essential to understand the other two concepts, namely inflation and capital gains. In simple terms, inflation is the general rise in prices, cost of goods and services, and a decrease in the purchasing power of money. 

For instance, what is worth Rs 200 today may be worth Rs 210 or more in the following year, and even more than the year after. In this way, inflation eats into your purchasing power. For the same amount of money, individuals will be able to buy fewer things year after year compared to what you can buy today. 

Therefore, the impact of inflation over the value of an asset cannot be ignored. It must be accounted for when taxing the difference between the buy and the selling price. 

Understanding Capital Gains

Any meaningful discussion regarding indexation is incomplete without introducing capital gains. It refers to the profit from selling any asset, either tangible or intangible. Investments in the capital markets are subject to capital gains taxation under the current tax regime, and it is proportionate to the capital gains from those investments. That means, the higher your gain, the higher is the tax amount and vice versa. 

Under the current tax regime, investments with tenure in excess of 36 months are considered long-term investments. Conversely, investments with a duration of fewer than 36 months are considered short-term investments.

A fixed-rate of 20 percent is charged as a tax on long-term capital gains with an adjustment for indexation. On the other hand, investors are taxed according to their income tax slab on short-term capital gains. These rates hold only for investments in debt ETFs, gold ETFs, and international ETFs.

There are, however, no indexation benefits on equity investments. For equity and equity ETFs, investments in excess of 12 months are considered long-term investments instead of 36 months. These instruments attract a short-term capital gain tax of 15 percent, irrespective of your income slab. 

For the long-term capital gains under equity and equity ETFs, there are no taxes if the realized gains are less than Rs 1 lakh. For gains exceeding that limit, a 10 percent capital gains tax is levied. 

How are capital gains calculated with indexation?

Suppose an individual has invested Rs 10,000 in a debt ETF or a debt mutual fund. On average, the return on that debt fund is 7 percent. At the end of a 5-year period, effectively, the investment grows to Rs 14,026 at a 7 percent annualized rate. The individual, however, has a tax challenge here. 

Given the fact that the individual held the debt fund for more than 3 years, it will be considered as a long-term capital gain (LTCG). The individual at the end of 5 years has a capital gain of (Rs 14,026 – Rs 10,000) or Rs 4,026. Should the individual pay tax on Rs 4,026?

Indexation Benefit

The answer is no, this is where indexation comes in. Although the individual earned a 7 percent annualized return on the investment, part of that return will be eaten away by inflation. For instance, assume further that the inflation over the investment period was 5 percent, on average. 

Then the inflated cost at the end of the 5-year period of investment of Rs 10,000 would be Rs 12,763. This implies that the individual’s effective taxable capital should not be Rs 4,026 but only (Rs 14,026 – Rs 12,763) or Rs 1,263. Now, this looks fair to investors as they can pay lower taxes. 

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

An inflation index tool is often used to measure the rate of inflation in the economy. To ensure standardization, the value of this index is determined by the central government and is increased every year to reflect the effect of inflation over that year. Otherwise, different individuals would apply different rates of inflation.

For example, somebody may apply September inflation, while someone else may apply the August inflation print, somebody may apply urban inflation while others may apply the rural inflation print, and so on. 

To remove these distortions and standardize the entire process, the Income Tax Department announces an annual index number for tax purposes, known as CII. The table below provides the index numbers.

Indexation Chart – Indexation table

Financial Year	Index Value
2001-02	100
2002-03	105
2003-04	109
2004-05	113
2005-06	117
2006-07	122
2007-08	129
2008-09	137
2009-10	148
2010-11	167
2011-12	184
2012-13	200
2013-14	220
2014-15	240
2015-16	254
2016-17	264
2017-18	272
Indexation Chart For FY 2018-19	280
Indexation Chart For FY 2019-20	289
Indexation Value for FY 2020-21	301

Source: Income Tax Website, GoI

These numbers, in the table above, act as a guide that all individuals paying capital gains must use for indexation in the corresponding year. When an individual buys in a particular year and sells in another, they must multiply the original acquisition cost by the selling year index number and divide by the buying year index number. 

How is indexation calculated?

Inflation-adjusted purchase price = Cost of acquisition * (CII of the year in which units were sold / CII of the year of purchase)

This results in an indexed cost of acquisition which will be higher than the original purchase price unless there is deflation. Investors only need to pay capital gains tax on the indexed value of capital gains. 

Indexation Formula – What is indexation example?

Let’s take an example to understand this completely.

Asset bought in 2016-17 (CII = 264) for Rs 1 lakh

Asset sold in 2019-20 (CII = 289) for Rs 2 lakh

To arrive at the indexed purchase price, take the CII for the year in which the asset was sold (i.e., 2019-20) and divide it by the CII for the year in which it was bought (i.e., 2016-17). The accumulation factor would be 289/264 or 1.0947. 

Now, multiply this by the cost of acquisition to deduce the indexed cost of acquisition. In this case, it is (Rs 1,00,000 * 1.0947) or Rs 1,09,470. 

Capital gains for taxation purposes would be equal to the selling price of the asset minus the indexed price, (Rs 2,00,000 – Rs 1,09,470) or Rs 90,530. 

Benefits of indexation

Investors use indexation primarily to adjust the purchase price of an investment to reflect the effect of inflation on it. A higher cost of acquisition implies lower profits, which translates into lower taxes. 

Therefore, through indexation individuals will be able to reduce their long-term capital gains (LTCGs), effectively bringing down the taxable income. Due to this, the attractiveness of debt funds, as a fixed-income instrument, increases many folds compared to the conventional fixed deposits (FDs). 

Is there any indexation for capital gains on shares?

Investors can benefit from indexation only on the below-listed asset classes:

1. Debt ETF / Debt mutual fund
2. Gold ETF
3. International ETF (Nasdaq 100 ETF / Hang Seng ETF)

Indexation for equity shares

There is no indexation benefit on equity shares or equity-oriented ETFs/mutual funds.

What is the cost inflation index for 2019-20?

The CII for 2019-20 was 289.

What is the cost inflation index (CII) for 2020-21?

The CII for 2020-21 is 301.

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