How and when does indexation work in taxation
Let us say you bought an asset for Rs100 and sold the asset after 3 years for Rs150. That would mean your taxable capital gains are Rs50, right? No, wrong. In reality you don’t enjoy this entire gain because some part of your gain gets eaten away by inflation. Indexation is a method in the Income Tax Act to give you compensation for inflation costs. Here are 3 things you need to know about indexation.
a) Indexation applies only to assets that are classified as long term assets under the Income Tax Act. That means indexation only applies to long term gains. There is no concept of indexation on short term assets and on short term capital gains.
b) Indexation does not apply to equities. In the case of direct equities and equity mutual funds, the rate of long term capital gains tax has been fixed at 10% on long term gains above Rs100,000 in one financial year. This is a flat rate of tax without indexation.
c) In indexation, the cost of acquisition is indexed by the index number, while the sale cost is taken at actuals. Since the buying cost is inflated, the capital gains considered for tax purposes reduces and hence the tax on capital gains also reduces proportionately.
So, what exactly is double indexation in practice?
To understand indexation, we first need to understand the concept of index numbers put out by the Income Tax Department for each fiscal year. The relevant index number for each financial year is announced by the Income Tax department and the table below captures the relevant index numbers for the last five financial years.
|FY 2016-17||FY 2017-18||FY 2018-19||FY 2019-20||FY 2020-21|
The financial year 2001-02 is considered as the base year with a value of 100. In short if you bought an asset for Rs100 in 2001-02 and sold it for Rs300 in 2020-21, then your capital gains will be Rs200 but your indexed capital gains will zero and hence you have to pay zero tax. Let us now move to double indexation.
Double indexation is the special benefit you get by buying an asset towards the end of the preceding financial year so that the older index number becomes applicable. This gives you a higher indexation benefit and reduces your capital gains and capital gains tax payable by just increasing your holding period for a few days. Here is how it would work in practice.
Double indexation versus single indexation of assets
Let us assume a scenario where an investor buys a debt fund on 03 April 2017 at NAV of Rs45 and sells the debt fund units on 06 April 2020 at a NAV of Rs66. Let us assume for simplicity that he bought 10,000 units of the fund and sold all the units in one go. We will also look at a second scenario where instead of buying these debt fund units on 03 April 2017, he had just bought these units 4 days earlier on 30 March 2017. Here is how it would make a difference to the taxation and that is the crux of double indexation.
|Particulars||Single Indexation||Double Indexation|
|Date of purchase of debt fund units||03 April 2017||30 March 2017|
|Date of sale of debt fund units||06 April 2020||06 April 2020|
|Purchase Value of 10,000 units||Rs450,000||Rs450,000|
|Indexed Value of Acquisition||Rs497,978 #||Rs511,132 #|
|# (450,000) x (301/272)||# (450,000) x (301/265)|
|Sale Value of 10,000 units||Rs660,000||Rs660,000|
|Indexed Capital Gains||Rs162,022||Rs148,868|
|Tax @ 20% on indexed capital gains||Rs32,404||Rs29,774|
|Actual Capital Gain made||Rs210,000||Rs210,000|
|Effective capital gains tax paid||15.43%||14.18%|
So, the moral of the story is that double indexation does work. In the above case, just by purchasing the debt funds 4 days early. Instead of purchasing the debt funds on 03 April, you bought the debt funds 4 days earlier on 30 March. That gives you the benefit of double indexation as you move to the previous financial year and hence that particular index number becomes relevant to you. By doing so, you are able to reduce your effective rate of capital gains tax by 125 basis points from 15.43% to 14.18%.
That is the reason, many closed-ended debt funds are often sold towards the end of the financial year with a tenure of 3 years and a few days so as to get the benefit of double indexation on capital gains tax.