We all expect handsome returns when we patiently invest our hard-earned money for years. But often, the sky-breaking inflation rates discourage investment returns from holding value. For instance, you invested in a debt fund for 3 with 7% returns. Now, the average inflation rate in India is around 7.4%. Considering the ‘Time value of money’ principle, all your returns got offset against inflation. Or did they? Not so easily. This is where indexation benefits come into play.
What are indexation benefits?
Indexation is a method to calculate the new value of our non-equity investments by adjusting the inflation factor. To say it another way, it recomputes your real capital gains as per the duration of the investment. But how does this benefit you? Well, debt funds held for the long term (more than three years) attract a tax rate of flat 20%. However, indexation benefits enable you to pay fewer taxes on these gains as they add an additional deduction that considers inflation.
How is indexation calculated?
Indexation is calculated based on the Cost Inflation Index(CII). Let’s decode that first. So CII, is an index that reflects the increase in the prices of goods and services in the current financial year. For example, the value of ₹100 in the year 2000 is as valuable as ₹371 in 2022. That’s an average depreciation of ₹12 rupees a year. The Income Tax Department issues CII annually, which mirrors the price rise. This CII is then used to calculate indexation benefits for investments.
CII for the last ten financial years is as follows:
| Financial Year | CII(Cost Inflation Index) |
| 2012-13 | 200 |
| 2013-14 | 220 |
| 2014-15 | 240 |
| 2015-16 | 254 |
| 2016-17 | 264 |
| 2017-18 | 272 |
| 2018-19 | 280 |
| 2019-20 | 289 |
| 2020-21 | 301 |
| 2021-22 | 317 |
Formula for indexation benefits:
= Purchase price – Indexed cost of acquisition
Here, Indexed cost of acquisition = Investment amount * CII in the year of sale/CII in the year of purchase.
Let’s say you bought an asset for ₹10 lakh in the year 2015-16 when the CII was 254. You sold it in the year 2019-20 for ₹15 lakh with a ₹5 lakh LTCG when the CII was 289.
Ignoring the indexation benefits, you would have to pay a tax of 20%, i.e. ₹1,00,000.
However, if you include indexation benefits, your taxes can be reduced by a whopping ₹11,000!
Indexation is applicable to debt mutual funds and other asset classes held for a long term. Hence, if when the economy forecast gets positive towards high inflation rates, it makes good sense to turn to debt securities.
