Explained: All About Debt Fund Taxation And Indexation 

The holding period must be three years to avail indexation benefits. Only debt mutual funds are eligible for indexation benefits and not direct bond investments.

Now that we are into March, the focus is on making various tax-saving investments. We will discuss a concept that is not about tax efficiency in the current financial year, but on an investment that will create a base (initial year for computation) for future tax efficiency.

The concept of indexation

While computing capital gains on debt mutual fund investments, there is significant tax efficiency over a holding period of three years. Here are some pointers.

-Investment must be in the growth option (as against the dividend option) of a debt mutual fund

-All debt funds are eligible, open and close ended

-Investment holding period must be a minimum of three years

– You may stay invested as long as you want. Indexation benefit is available for each financial year you stay invested in

-Indexation benefit is available only for debt mutual funds; not for direct bond investments

The rationale for giving the indexation benefit is that the gains while redeeming your investment are partially due to inflation, apart from market movements. Since it is not fair to tax you on gains due to inflation, you are given a commensurate leeway.

How does it work?

There is a cost inflation index (CII) declared for the financial year by the Government, in particular the Central Board of Direct Taxes. Your purchase or acquisition cost is “indexed” for each financial year you remain invested. The capital gains, for taxation purposes, are computed as sale price or redemption price minus the indexed cost of acquisition.

The CII number for the financial year is usually declared in the second quarter – July-September – or sometimes in the third quarter, i.e., October. As per definition, the CII is valued at 75 percent of the CPI inflation in the previous financial year. However, historically, the benefit given is more than 75 percent of CPI inflation in the previous year. That is, the authorities have been benevolent in giving the benefit of inflation for LTCG (long-term capital gains) on debt funds.

Illustration:

Let’s say you invested in a debt fund on September 14, 2017, at an NAV of Rs 10. You redeemed the fund on December 13, 2020, at an NAV of Rs 12. You are eligible for indexation as you have been invested for more than 3 years. The CII for financial year 2017-18, as declared by the Government, is 272 and that for FY 2020-21 is 301. Hence your purchase cost is indexed up to 301/272 X Rs 10 = Rs 11.66. Your capital gains, for the purpose of taxation, is Rs 12 minus Rs 11.66 = Rs 0.34.

The rate of long-term capital gains tax on debt funds is 20 percent. There are elements of surcharge and cess, but we are ignoring those for the sake of simplicity. The tax payable is Rs 0.34 X 20 percent = Rs 0.068. On a capital gain of Rs 12 minus Rs 10 = Rs 2, the effective tax incidence is Rs 0.068, i.e., 3.4 percent, calculated as tax incidence as a percentage of capital gains.

The interest on bonds is taxable at your marginal slab rate of 30 percent (plus surcharge and cess as applicable). Debt fund short-term capital gains are taxable at the same rate.

Depending on the inflation and CII figures declared by the Government, your effective tax incidence percentage would be in single digits.

Conclusion

For the benefit of indexation for LTCG on debt funds, there is no specific time for investment, any 3-year or longer holding period would suffice. Having said that, if you invest by 31 March 2021 and redeem in April 2024 or later, your base or initial financial year will be 2020-21. If you invest in say April 2021, your year of investment will be 2021-22. This makes a difference of one year of indexation benefit.

In the first eight months of 2020-21, inflation was on the higher side. Thereafter, inflation has been easing. But the average for the year will still be on the higher side. Depending on your cash flows, if you can execute your debt fund investment by March 31, 2021, you can take the indexation benefit in the form of a relatively higher CII number for 2021-22, which would be declared sometime in the second quarter, i.e., July-September 2021.

Source: https://www.moneycontrol.com/news/business/personal-finance/explained-all-about-debt-fund-taxation-and-indexation-6618151.html

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