Double Indexation – Meaning and Benefits

The fag end of the financial year is the time for tax savings strategies. I am not talking about investing in the section 80C to save tax. This article is about double indexation benefits and how it can reduce your tax outgo in the coming years. If you are investing in bank deposits and pay tax on the interest, you will find this article interesting.

Indexation Meaning

It is adjusting the purchase price of an asset to offset the impact of inflation, primarily for the purpose of calculating capital gain tax. Adjusting purchase price means scaling it upwards based on the inflation during the period.

Depending upon the duration for which the asset was held with the investor, the capital gains are termed as short term capital gains and long term capital gains. For shares and equity mutual funds if it is sold within 1 year of purchase, the gain is considered as short term capital gain.  If it is held for a period exceeding 1 year, the gains are called long term capital gains.

Why indexation is necessary?

Indexation helps the investor to adjust the purchase price according to the inflation in the market and pay tax only on the actual gain. Suresh invested Rs.1000 in Debt mutual fund in 2008- 09 and sold it for 1500 in 2012-13. The value 1000 has to be adjusted to reflect the inflation during the year 2008 – 09 and 2012 – 13, and then compared to the Rs. 1500 of 2012- 13 to calculate the actual capital gain.

How indexation is applied and how it will reduce your tax?

Cost inflation index (CII) numbers are released by government every year in line with the inflation in the economy. We can calculate the indexed cost of the asset by knowing the CII numbers. The CII number for 2008-09 was 582 and for 2012-13 were 852.

 In the above example of Suresh, the indexed cost in 2012-13 will be 1000 x 852/582 = 1464.

In this case, the long term capital gain will be 1500 – 1464 = 36.

The tax liability on this is 20%. So, Suresh has to pay a tax of Rs.7/- on this gain (20% of Rs. 36/-).

You can see that though the actual gain is 500 (1500 – 1000 = 500), for taxation purpose, the long term capital gain will be only 36 and the tax liability is nominal.

If the same gain of 500 was made from bank interest, the tax liability was on the entire gain of 500 and that too as per your tax slab. If Suresh is in the 30% tax bracket, he has to pay tax of 150 on this. What is more? In bank deposit, you have to pay tax in the year of accrual and not at the time of maturity of the deposit. But in debt funds, you have to pay tax only at the time of sale. Investing in a debt mutual fund is better than investing in bank deposit from taxation angle.

Double Indexation Benefits

Double indexation benefit is, enjoying indexation benefit for 2 years when the investment is held for little more than 1 year. Let me explain with an example.

Suresh invested 1, 00,000 in a debt mutual fund on 1^st April 2011 and redeemed it on 1^st April 2012. The holding period is just 1 year. He got 1, 09,000 by way of redemption. The gain is 9000. How to calculate the tax liability on this gain of 9000?

The CII for 2011-12 is 785 and that for 2012-13 is 852.

The indexed cost of investment is 1, 00,000 x 852/785 = 1, 08,535.

Long term capital gain for taxation = 1, 09,000 – 1, 08,535 = 465.

Tax to be paid on this gain = 20% of 465 = Rs.93/-.

Now, let us assume that Suresh invested this 1 lakh on 31^st March 2011 and redeemed it on 1^st April 2012. In this case, the holding period is 1 year and 1 day, but there is a change in the financial year and the tax calculation is changed.

The CII for 2010-11 is 711 and that for 2012-13 is 852.

The indexed cost of investment is 1, 00,000 x 852/711 = 1, 19,831.

Long term capital gain for taxation = 1, 09,000 – 1, 19,831 = (10,831).Yes, it is a Loss!

Yes, your actual gain of 9000 will be taken as a loss of 10,831 for taxation.

What way you benefit in this by way of double indexation?

There is no need to pay any tax on your actual gain of 9000/- What is more? You can adjust this loss against other capital gain and reduce your tax liability! You can also carry forward this loss to the next 8 years and adjust against any capital gains in future!!

So, if you are keeping huge amount in bank deposit and is paying tax on the bank interest, think about debt funds and how they can help you in saving income tax. There was a proposal to amend this rule in the proposed DTC. But it is not a reality now. Till then enjoy.