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Have you ever given a thought as to how long-term capital gain tax is calculated? If no, then start doing the same as it could put you in a good position as far as your investment portfolio is concerned. Inflation erodes the value of investment over a period of time. So, the purchase price must get adjusted with the levels of existing market price in order to compute tax on the return of the investment. This is where the role of indexation comes into play. It is a process to adjust the purchase price for inflation to calculate long-term capital gain tax. With this, an investor is taxed only on the capital gain over and above the price rise due to inflation.
The indexation is applicable in a series of investments like equity & debt mutual funds, fixed maturity plans (FMPs), real estate, stocks, etc. The benefit of indexation is provided to these investments held for a period of 1-3 years. But, bear in mind that long-term capital gains applies for investments held for over a year. Also, you can suffer from capital loss with indexation. Ideally, one should adopt a long-term approach to get the benefit of indexation in the true sense as selling the investment in a shorter period of say 2-3 years can lead to capital loss even if you manage to reduce the tax liability with the said mechanism. So, there is a need to understand the intricacies of indexation so that you can sell your mutual fund investments at the right time to book profits and at the same time reduce your tax liability.
How is capital gain ascertained?
The government has constructed an index known as the cost of inflation index (CII). The base year of the index is 1981-82 and the value for the year is 100. The value of index gets declared each financial year. The ratio of inflation index at the time of sale of the investment to the value at the time of purchase is taken into consideration while calculating long-term capital gain. The value so obtained is multiplied by the cost of the acquisition of the investment. Thus, you get the indexed cost of acquisition or say inflation adjusted purchase price, which then subtracted from the sale consideration to obtain capital gain/loss.
Formula for inflation adjusted price=Purchase Price × CII of the year sold/CII of the year purchased
Capital Gain/Loss=Sale Consideration -Inflation Adjusted Price
For example– If you had purchased a debt mutual fund scheme at Rs 50,000 on 20th April 2013 and its maturity was on April 2014, then the capital gain thus ascertained would have been in accordance with the ratio of 1024 and 939, the cost of inflation index for FY 2014-15 and FY 2013-14, respectively. The ratio was (1024/939)=1.09. Inflation adjusted price would have been be Rs 20,000×1.09=Rs 21,800. If the investment offered a return of 10% per annum, then sale consideration would have been Rs 22,000. Capital gain would have been Rs 22,000-Rs 21,800=Rs 200
How can you reduce capital gain tax with indexation?
As we now get to know that the indexed cost of acquisition or the inflation adjusted price is dependent upon the ratio of the cost of inflation index at the time of booking profit to its value. So, higher the number it will be, lower will be the tax you pay. Inflation also adds up over a period of time so it can result in massive reduction in the taxable amount. Inflation can eat up small gains over a long period of time. In that case, you may not have to pay any tax.
In case of mutual fund, indexation benefit is available for investments held for at least a year. But since inflation for the financial year is taken into account, so if you invest for over a year and it extends to three financial years, you stand to get the inflation benefit of two financial years. This is known as double indexation. The USP of double indexation is that you get the same even if you have invested for less than 2 years. Because, there are chances that your investment could come in the range of 3 financial years. If you had invested in March 2011 and redeemed the investment in April 2012, you will avail the double indexation benefit. Because, the investment had covered three financial years- FY 2010-11, FY 2011-12 and FY 2012-13. Fixed maturity plans offer double indexation benefit more than any other asset class as they have a maturity period of slightly above a year.
How to get double indexation benefit?
Suppose you made an investment of Rs 40,000 in FMP in March 2014 of FY 2013-14 and redeemed the same in April 2015 of FY 2015-16. If the rate of return on the investment was 10%, the redemption value of the fund must have been Rs 43,200. The index cost of acquisition will take into the consideration the inflation index for FY 2013-14 and FY 2015-16. The CII for FY 2013-14 and FY 2015-16 are 939 and 1081, respectively. Indexed cost of acquisition thus would have been Rs 40,000×1081/939=Rs 46,049. The long-term capital gain would have been Rs 46,049-Rs 43,200=-Rs 2,849. Here, you would have faced a capital loss of Rs 2,849. There would not have been any tax liability on the same. But since it is a loss, you have the provision of carrying forward this for 8 years or offset with long-term capital gains.
Long-term debt mutual funds qualify for indexation benefits. For capital gain on investments held over a year, tax rate could either be 10% without indexation and 20% with indexation. Tax rate on long-term capital gain on property, gold remains 20% with the indexation of cost.
Now, you have got the details to use indexation to reduce your tax liability on the long-term capital gain of your mutual fund investments. But make sure to check whether you are gaining profit or not with indexation. See if the indexed cost of acquisition is eating out your profit or not. If it is, then you can look for a better time to sell your mutual funds and gain the profit thereof.