Lower your tax liability with indexation

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

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 -

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.

Above article is authored by Quantum.

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