In investment it is stated that – Inflation is a silent killer. Inflation means, things are going to cost us higher tomorrow than what we are paying today. And this is applicable to most of the things (with few exceptions where technology is bringing down the cost significantly). While inflation is reducing the purchasing power, it also affects the returns generated through our investments. For instance, if one’s investments have generated 8 per cent per annum and the inflation stands at 3 per cent, their net net returns generated are less than what it looks at superficial levels. If one adds the tax impact to that, it’s even lower.
For equity mutual funds and hybrid mutual funds the returns are usually on the higher side (naturally the risk is also higher). However, when it comes to debt-oriented funds the returns are just marginally higher than the risk free returns. In such cases, the inflation cost plays a vital role. And hence, indexation is an important part to understand.
What is Indexation?
Indexation is defined as adjusting the purchase price of mutual funds investment to reflect the impact of inflation. The inflation impact reduces the net returns generated and the impact of the same is significant in debt oriented mutual funds schemes. Thus, to adjust the returns generated to the inflation levels would provide some solace to the investors at least on the taxation front. That’s when indexation comes to the rescue!
Indexation is a system of economic regulation where wages and interests are tied to the cost of living index in order to reduce the effects of inflation. Indexation, therefore, helps in keeping a check on the gain or loss on an investment. It is a technique by which income payments are adjusted by means of a price index so as to maintain the purchasing power of the individual after inflation. The benefit of Indexation is to help one regulate the purchase price of the investment, applicable to long term investments, including debt funds.
How to calculate Indexation or Indexed Cost of Investment?
Indexation helps in understanding the actual purchase price of mutual funds investment to reflect the impact of inflation. And for that, one must understand the concept of cost inflation index (CII). CII is calculated to match the prices to the inflation rate. An increase in the inflation rate over time will lead to a rise in the prices. The Central Government specifies the CII by notifying in the official gazette. CII is a tool used in the calculation of an estimated yearly increase in an asset’s price as a result of inflation. Now 2001-02 is considered a base year.
CPI (t) = (C_t/C_0) * 100
CPI (t) - Consumer price index in current period
C_t - Cost of market basket in current period
C_0 - Cost of market basket in base period
Cost Inflation Index = 75 per cent of the average rise in the Consumer Price Index* (urban) for the immediately preceding year.
Now as we understand the concept of calculating the Cost Inflation Index, let us understand how to calculate Indexation.
Indexation is calculated as follows :
Amount Invested (CII for year of year of Sale/CII for year of purchase)
CII – Cost Inflation Index (Released every year by income tax department)
The above calculation gives us an ‘Indexed Cost’ of investment.
How is Indexation Applied?
Let us understand this with the help of an example. Suppose Mr. X purchased a debt mutual fund of 5000 units at Rs. 20 in the financial year 2015-16 and later sold it at Rs. 23 in the financial year 2018-2019. As the units were held for more than 36 months the same qualifies for indexation benefit. The initial investment was Rs. 1,00,000 (Rs. 20 * 5000 units) and the current value stands at Rs 1,15,000 (Rs 23 * 5000 units). Here the profit made by him would be Rs. 15,000. In a normal taxation the capital gains coming under taxation would be Rs. 15,000. However. if the same is calculated based on indexed cost the figures would be completely different.
Put in the formula mentioned for Indexation it is as follows
Indexed Cost of Purchase will be:
Rs 100000 *(288/254)
= Rs 1,10,236
This means the profitability would be Rs 1,15,000 – Rs 1,10,236 = Rs 4754.
If we calculate the taxations based on normal profit – it comes to Rs 15,000 *20 % = Rs 3000.
However if we take the indexed level profit the taxation would be – Rs 4754 *20% = Rs 953.
Following table elaborates the same in detail:
Conclusion: The indexed price arrived at is used to calculate the capital gains on which LTCG tax of 20 per cent plus surcharge of 10 per cent plus education cess of 4 per cent is applicable. There is a direct relation between the inflation level and the indexation benefits. Meaning, if inflation has been high in the period between the purchase and sale of the investment, then the indexed cost of acquisition of the investment will go up. Eventually reducing the gains on which the taxation is applicable. One must understand that, Indexation adjustment of purchase price is done just for calculating the tax on capital gains. It does not mean that the actual gains or profit made will reduce.