Lower your tax liability with indexation

Posted On Wednesday, Sep 17, 2014

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Tax indexing on long term capital gains which was optional until this year is the norm now. The new Union Budget announced in July 2014 has done away with the option tax payers had of choosing between a lower tax rate on income calculated without indexing and a higher rate on income after indexing.

All investors may not be familiar with the concept of indexation however it is fairly simple to do. Here is an easy guide on indexing for taxation.

What is indexing for tax?
Time erodes the value of money. 10 years back the value of Rs 100 was much more than what it is today. If Rs 100 were sufficient to buy 2 days’ grocery back then, today Rs 100 would buy less than 3 litres of milk. In fact Rs 100 of a decade back is equivalent to Rs 240 today at 9% inflation rate. This phenomenon is what we commonly refer to as inflation.

Now while calculating our tax dues on profit we’ve earned from long term investments we are to adjust the original investment to the value it would be today due to inflation. This is done by indexing the invested amount against inflation.

Essentially tax indexing is done because inflation makes the income from long term investments look greater than its real purchasing power.

Applying tax indexation to mutual fund returns
Suppose you invested Rs 1,00,000 a decade ago in a Gold Fund and redeem the investment today which has grown to Rs 2,50,000. Your profit on this investment is Rs 1,50,000. In tax parlance you have made Long Term Capital Gains (LTCG), and a tax becomes due. Equity mutual funds are exempt from long term capital gains tax; all other funds – gold funds, debt funds, balanced funds and (unfortunately) equity fund of funds attract this tax.

This is how you can apply indexation to your mutual funds taxation:
i. Inflate the invested amount by indexing it.
For this you need to refer to the Cost Inflation Index (CII) which is released by the Tax Department every year. Then calculate the indexed invested amount as

CII of the year of redemptionX Invested Amount
CII of the year of investment


ii. Subtract the indexed invested amount (instead of the original invested amount) from the redemption amount.

iii. Calculate tax on this indexed capital gain at the applicable tax rate.
Here is an illustration of the steps using the Gold Fund example above -

i. Indexed invested amount=



=



=
CII of 2014X 1,00,000
CII of 2014
1024X 1,00,000
480
2,13,333
ii. Long term capital gain=

=
2,50,000 - 2,13,333
36,667
iii. Applicable tax amount=

=
20% of 36,667
7,333


Without indexation the tax would be 10% of the capital gain, which is 10% of 1,50,000. This amounts to Rs 15,000. Here indexation has reduced the tax amount by nearly Rs 7,667. Thus your tax outgo in this case is lowered by adopting the 20% tax with indexation rule.

Note that the indexation rule is beneficial only when the investment is fairly long term. In shorter periods the 10% tax rate might work out to be lower. Nevertheless now investors do not have the choice; they must apply indexation on all investments held for 3 years or more.

But indexation is better than you thought!
In the paragraph above you saw how indexation lowers your tax compared to the non-indexed capital gain. However there’s more to it than that. In some situations this provision would actually make your profit a capital loss!

Suppose you invested Rs 10,000 in a bond fund 5 years back and your redemption proceeds this year is Rs 14,000. That’s a profit of Rs 4000. However on indexing the invested amount, you get a loss of Rs 2,203.

This means no tax to be paid at all What's more, you can carry forward this capital loss and set it off against any long term capital gains in the next 7 years!

So now you have another reason to keep investments in gold funds, bond funds and multi asset funds for the long term. Plan your investments wisely and use indexation to minimize (or nullify!) your taxes. Consult a good financial advisor for your investment needs.



Disclaimer, Statutory Details & Risk Factors:
The views expressed here in this article are for general information and reading purpose only and do not constitute any guidelines and recommendations on any course of action to be followed by the reader. The views are not meant to serve as a professional guide / investment advice / intended to be an offer or solicitation for the purchase or sale of any financial product or instrument or mutual fund units for the reader. The article has been prepared on the basis of publicly available information, internally developed data and other sources believed to be reliable. Whilst no action has been solicited based upon the information provided herein, due care has been taken to ensure that the facts are accurate and views given are fair and reasonable as on date. Readers of this article should rely on information/data arising out of their own investigations and advised to seek independent professional advice and arrive at an informed decision before making any investments. Please visit – www.quantumamc.com/disclaimer to read scheme specific risk factors.

Above article is authored by Quantum.

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