Indexation is a system of economic regulation to reduce the impact of inflation by tying the cost of living index to determine wages and interests. I know this is a highly confusing statement but continue reading to understand the indexation benefit and its concept. I will share an example with you in order to simplify the concept for better understanding.
Let us say you bought apples worth Rs. 200 per kg. You buy them and store them with yourself. 2 weeks later the price of 1 kg apples go up to Rs. 225. You sold the same batch of apples at Rs. 245 per kg. What was your profit?
Considering that the market price of 1 kg apples was Rs. 225 at the time you had sold them, your profit will be Rs. 245 - Rs. 225 = Rs. 20.
Now when it comes to investment, the indexation benefit is applicable on long term capital gains, specifically on Debt Mutual Funds.
As mentioned earlier, the indexation benefit relies on the Cost of Inflation Index, so what is this CII and how do we come to CII. The Cost of Inflation Index number is notified by the Finance Ministry for every Financial Year on the Income Tax Website.
Sarita invested Rs. 2 lakhs in a debt mutual fund scheme in 2017. After 3 years, in 2020, she redeemed the investments and got Rs. 2,50,000. So the capital gains here were Rs. 50,000
Since she held on to these investment for a period of more than 3 years, the gain on the investment is Long Term Capital Gain. Hence she will get the indexation benefit and won’t pay tax on entire amount of Rs. 50,000
The formula used to adjusted CII is as follows:
Inflation-Adjusted Purchase Price = Actual Purchase Price x (CII in the year of sale/CII in the year of purchase)
So,
Inflation-Adjusted Purchase Price = 2,00,000 x (289/264) = 2,18,939.39
To calculate capital gains after indexation benefit we will apply the following formula:
Capital Gain (after indexation) = Redeemed investment amount - Inflation-adjusted purchase price
Capital Gain (after indexation) = Rs. 2,50,000 - Rs. 2,18,939.39
Capital Gain (after indexation) = Rs. 31,060.61
Sarita will therefore have to pay a tax on Rs. 31,060 rather than paying tax on the entire capital gain amount of Rs. 50,000.
Since the tax rate on LTCG is 20%, therefore tax payable will be Rs. 6212.12. So, the tax amount saved in this process is Rs. 3,787.88.
Here is a table to clearly show you the indexation benefit of the above calculation.
Without indexation (Rs.) |
Without Indexation (Rs.) |
With Indexation Benefit (Rs.) |
Initial Purchase Price |
2,00,000 |
1,00,000 |
Inflation Adjusted Purchase Price(using CII) |
2,00,000 |
2,18,939.39 |
Redemption Amount |
2,50,000 |
2,50,000 |
Capital Gain After Indexation |
50,000 |
31,060.61 |
Total Tax Paid |
10,000 |
6,212.12 |
What is Indexation Benefit?
Rishabh
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2021-04-15T18:42:20+00:00 2021-04-22T12:42:41+00:00Comment
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