What is Indexation ?
In
today’s scenario of lower interest rates resulting in lower YTMs (Yield
to Maturity) of debt and liquid mutual funds, it is imperative for an
investor to focus on real returns (inflation-adjusted) on a post-tax
basis. On one hand, a sustained low inflation is making even lower
returns attractive on a real basis, and on the other, the investor can
also reduce the impact of taxation by making use of the indexation
benefit.
Definition
Indexation is a technique to adjust income payments by means of a price index, in order to maintain the purchasing power of the public after inflation, while deindexation is the unwinding of indexation.
What Is Indexation?
A
long term debt investments (of at least 3 years), qualifies for
indexation benefit in the calculation of long term capital gains under
Income Tax Act, 1961. Indexation is nothing but the increase in the cost
of acquisition of the asset. This increase is based on a “Cost
Inflation Index (CII)” which is updated every year based on inflation.
Therefore, for a holding period covering 4 financial years, the cost of
acquisition of the debt mutual fund units are multiplied by the CII of
the year of sale and divided by the CII of the year of purchase –
thereby increasing its value by 3 indexations.
Index Cost of Acquisition =
Cost of acquisition x CII of year of sale/CII of year of purchase
What is 4-indexation benefit?
What is 4-indexation benefit?
Interestingly,
it is also possible to earn the benefit of 4 indexations by increasing
the holding period of 3 years just by a few months. For example, an
investment made in January, 2020 and redeemed in April, 2023 covers 5
financial years, i.e., FY 2019-20, 2020-21, 2021-22, 2022-23, and also
FY 2023-24 as the investment is sold in April, 2023. Therefore, the
investor earns the benefit of 4 indexations by investing only for 3
years and 3 months, provided his holding period is such that it covers 5
financial years.
Explained
in the below table is the difference in post-tax returns of investments
in debt mutual funds Vs term deposits made on 1st Jan 2020 and redeemed on 1st April 2023, assuming a CAGR of 6.5% for both:
Therefore, the additional indexation benefit can positively impact our return in a significant manner. This presents investors the opportunity to enter the debt markets over the next three months till the end of the current financial year with a holding period running over 1st April 2023.
Sources:
Various publications
Disclaimer: The
information provided herein is based on publicly available information and
other sources believed to be reliable, but involve uncertainties that could
cause actual events to differ materially from those expressed or implied in
such statements. The document is given for general and information purpose and
is neither an investment advice nor an offer to sell nor a solicitation. While
due care has been exercised while preparing this document, we do not warrant
the completeness or accuracy of the information. We will not accept any
liability arising from the use of this material. The recipient of this material
should rely on their investigations and take their own professional advice.
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