Indexation Explained: Understanding Its Significance, Advantages, Formula, and Calculation
Indexation Benefit in Long-term Capital Gains (LTCG) Tax for Debt Mutual Funds in India
Indexation in long-term capital gains (LTCG) tax for debt mutual funds in India helps investors reduce their taxable capital gains by adjusting the purchase cost of the investment for inflation. This is achieved using the Cost Inflation Index (CII), a figure issued by the Central Government every year that represents the year's inflation.
The original purchase price is multiplied by the ratio of the CII in the year of sale to the CII in the year of purchase, increasing the cost base and lowering the capital gain on which tax is calculated. LTCG from debt mutual funds held for more than 36 months was historically taxed at 20% with indexation benefit.
However, there have been significant changes effective April 1, 2023. For debt mutual fund investments made before April 1, 2023, LTCG on units held for more than 36 months continues to be taxed at 20% with indexation benefit if sold before July 23, 2024. After July 23, 2024, LTCG on these older investments will be taxed at a lower rate of 12.5% but without any indexation benefit.
For debt mutual fund investments made on or after April 1, 2023, indexation benefits have been removed entirely. All gains from these investments are treated as short-term capital gains (STCG) regardless of holding period and taxed at the investor’s applicable income tax slab rates, with no benefit of inflation adjustment.
Summary Table
| Investment Date | Holding Period | Tax Treatment | Indexation Benefit | |--------------------------|------------------------|---------------------------------------------------|--------------------------| | Before April 1, 2023 | > 36 months | LTCG taxed at 20% with indexation (till July 23, 2024) | Available until July 23, 2024 | | Before April 1, 2023 | > 36 months | LTCG taxed at 12.5% without indexation (after July 23, 2024)| Not available | | On or after April 1, 2023 | Any holding period | Gains taxed as STCG at slab rates | Not available |
How indexation reduces tax:
For example, if an investor named Shashi purchased a debt mutual fund at INR 1,00,000 in FY 2016–17 (CII 264), and sold it at INR 1,50,000 in FY 2020–21 (CII 301), the indexed cost would be calculated as follows:
Indexed Cost = 1,00,000 × (301 ÷ 264) = INR 1,13,999
The taxable gain would then be calculated as:
Taxable Gain = 1,50,000 – 1,13,999 = INR 36,001
With indexation, the tax liability would be reduced, as the tax would be calculated on INR 36,001 instead of the original gain of INR 50,000.
Thus, indexation benefits applied only to long-term holdings before April 2023 and have been phased out for new investments and largely removed even for older investments beyond July 2024. Indexation aims to account for the decrease in the asset's purchasing power caused by inflation over time.
- In personal-finance, debt mutual funds in India offer investors the advantage of indexation in long-term capital gains (LTCG) tax, which helps reduce taxable gains by adjusting for inflation using the Cost Inflation Index (CII).
- For investments in debt mutual funds made before April 1, 2023, investors can still benefit from the indexation benefit on LTCG if the units are held for more than 36 months and sold before July 23, 2024, as these gains will be taxed at 20%.
- If one started investing in debt mutual funds on or after April 1, 2023, the indexation benefit has been removed entirely, and all gains from these investments will be treated as short-term capital gains (STCG) and taxed at the applicable income tax slab rates, without any benefit of inflation adjustment.
- Technology plays a role in this context, as it facilitates the calculation of indexed costs and taxable gains, making the process more efficient for investors.
- Lastly, it is essential to understand that indexation aims to account for the decrease in the asset's purchasing power caused by inflation over time, thus becoming an essential aspect of effective long-term investing in mutual funds.
