A silent killer lurks in the midst of all our investments. It's called inflation and it steadily and silently eats into all our returns. And on these diminished returns, one also has to pay capital gains tax. But it's not that there is no cure for this malady. There is one called indexation benefit.
The basis of this concept is that inflation eats into returns and so tax should only be paid on the real part of gains. Based on this, investors have the option of paying long-term capital gains at the rate of 20 per cent with indexation benefits. There is also the option of paying a flat long-term capital gains tax of 10 per cent and investors can choose either option that is more favourable.
In order to make the computation of the actual gains component, the government constructs an index called the cost of inflation index. This index has its base year as 1981-82 and the value for that year is 100. Subsequently for each financial year, the value of the index is declared. To determine the gains component on which tax has to be paid, the ratio of the inflation index at the time of sale of the instrument to its value at the time of purchase is taken. This is multiplied by the cost of acquisition of the asset. This gives the indexed cost of acquisition.
In order to determine the capital gains after accounting for inflation, the indexed cost of acquisition is subtracted from the sale consideration. We can understand this with an example also. Suppose we had invested Rs 10,000 in financial year 2000 and redeemed in financial year 2001. The ratio of the inflation index at the time of sale (2000) of the instrument to its value at the time of purchase (2001) works out to 1.043 (406/389). The indexed cost of acquisition will work out to Rs 10,437. If the investment returned seven per cent, the sale consideration would be Rs 10,700. The capital gains in this case work out to Rs 263 (Rs 10,700 minus Rs 10,437).
As the indexed cost of acquisition depends on the ratio of the cost inflation index at the time of booking profit to its value, the higher this number is the lower the tax you pay. Over long periods of time, inflation also adds up and so on a cumulative basis this can lead to considerable reduction in the taxable amount. For small gains over long periods of time, the entire gain may in effect be nullified by inflation. In such cases one may actually not have to pay any tax. This is a very fair situation because if inflation has eaten up returns, then paying tax on your meagre returns does not make sense, as the gain is only notional.
The most popular ways of using the benefit of indexation is to extend booking profits so that it extends over two financial years. As a result one can get the indexation benefit of 2 years at a go. So if an investment is made before March 31 of a particular year and redeemed in the next financial year this benefit can be achieved. By investing for a few days more, a reasonable saving can be made.
While using the indexation benefit, it must be remembered that it applies to cases where a long-term capital gains is made. It is here that debt mutual funds benefit over other fixed interest instruments. The earnings from bonds and fixed deposits are always received as interest and the marginal rate of taxation for this is as high as 33 per cent. Further, the full earnings are taxed while in the case of capital gains only the gain is taxed. In situations like systematic withdrawal, a part of the capital also comes out and this reduces the overall tax, which has to be paid.
On the whole, whenever long-term capital gains tax is being paid, do check out the cost inflation index to see if the 20 per cent tax with indexation benefit is more suitable for you.