In an interview to CNBC-TV18 personal finance expert Lovaii Navlakhi of International Money Matters explained the concept of indexation and how one can benefit from it.
Below is the verbatim transcript of his interview on CNBC-TV18
Q: What is indexation? How does indexation work to reduce an investor’s tax liability? Practically speaking how should investors go about benefiting from the same?
A: There are quite a few things to remember about indexation. One is that indexation is applicable or there is a method by which you can reduce your taxes, only for categories where there is tax in the first place. Equity funds are exempt and those will not get covered. However, one could cover debt mutual funds, you could cover property, gold and also physical assets that you invest in.
When you look at indexation you get the benefit of inflating the cost of your purchase and it depends on when you have purchased the particular asset. For example let us say you have purchased a debt mutual fund three years ago and you are deciding to sell it now. What would happen is that the cost of the purchase would be inflated. The Government of India basically declares an inflation index every year and it is roughly about 75 percent of the Consumer Price Index (CPI) inflation. It is added to the inflation index, so to that extent, your cost will go up.
Let us say I invested in a debt mutual fund three years ago and I sold it in this financial year. I had bought it at Rs 100 and I sold it at Rs 130-135, because I got about 10 percent per annum return. The cost of that purchase of Rs 100 will be inflated to the inflation index and because inflation was higher in the last three years and according to rough calculation there is a 35 percent increase in the cost of that product. So, the Rs 100 that you invested will be actually treated as if the purchase cost was Rs 135. Now, in case you sold it at Rs 135, then there is no capital gain tax. But if you had sold it at Rs 140 then you would pay capital gains tax on only Rs 5 instead of Rs 40. So, on that Rs 5 is what you pay the capital gains tax.
The important thing to remember is that when I use indexation, the capital gains tax increases from 10 percent to 20 percent. Most importantly, one must keep in mind that indexation is applicable only for long-term capital gain. So if I have held for more than 12 months for a debt mutual fund, and I have held for more than three years for a property or for physical assets like gold only then indexation comes into play.
Moreover, if I am using a debt mutual fund I have an option to apply either a 10 percent long-term capital gains tax and take no impact of indexation or I can take a 20 percent capital gains tax plus the surcharge, so it becomes 20.6 percent and take into account the inflated cost.
In the above example if I bought at Rs 100 and I sold at Rs 140, I have a gain of Rs 40 and I can pay Rs 4 tax which is long-term capital gains tax or I index it and my purchase becomes Rs 135, so my gain is only Rs 5, I pay 20 percent of that which is only Rs 1 tax. So there is a big advantage to be made if I use indexation.