The longer your debt MF holding period, the higher will be the real indexation benefit, and vice versa.
We have all heard of indexation in debt fund taxation, but have you wondered how it works. Here’s an explanation with an illustration.
Rationale and conditions
The rationale for giving the indexation benefit is that since the capital gain is partially the result of inflation, apart from market movements, this benefit helps offset the inflation aspect in debt fund returns. You have to invest in the growth option (as against dividend option) of a debt MF and your holding period should be 3 years or longer. You get indexation benefit for each financial year you stay invested. Indexation benefit is available only for debt mutual funds and not for direct bond investments.
The indexation benefit is computed based on a cost inflation index (CII) announced by the tax authorities every year. Your purchase cost or acquisition cost is ‘indexed up’ for each financial year for which you are invested in the fund. Capital gains for taxation purposes , is computed as sale price or redemption price minus the indexed cost of acquisition. You pay tax at 20 per cent plus surcharge and cess on the taxable capital gains.
The CII number for the financial year is declared usually in the second quarter of that year i.e. July to September or as an exception, in the third quarter, for example, in October. Hence you can plan accordingly. However, if you redeem in say April or May, it may lead to complications for NRI investors due to incidence of tax deduction at source (TDS) as the MF cannot give benefit of indexation for that year. However, the NRI investor can claim it later while filing returns.
Illustration of indexation benefit
You invested in a debt fund on August 13, 2017 at an NAV of ₹10. You redeemed the investment on October 17, 2021 at an NAV of ₹12.50. 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 2021-22 is 317. Hence, your purchase cost is indexed up to 317/272 x ₹10 = ₹11.65.
Your capital gains for the purpose of taxation is ₹12.50 minus ₹11.65 = ₹0.85. The tax payable is ₹ 0.85 x 20 per cent = ₹0.17. On a capital gain of ₹2.5 (₹12.5 minus ₹10), the effective tax incidence is ₹0.17 or 6.8 per cent, that is, tax incidence as a percentage of actual capital gains. The longer your holding period, the higher is the benefit, and vice versa.