Inflation actually erodes returns on all your investments. While paying taxes one should know how much return has actually been eaten up by inflation. Indexation helps you understand this and reduces the tax burden.
Mar 12, 2003
Q. What is indexation? How does it help an investor?
A. Inflation—constant erosion in real value of money through a rise in prices—is a fact of life. Over the last few years though inflation in India has been relatively low—in the 3-6 per cent range. In the earlier years, inflation was generally on the higher side. The compounding effect of even moderate inflation rates over many years can really depress the real gains you make on an investment. You may have made an investment that has quadrupled over the last 15 years, but the purchasing power of money is down to less than half of what it used to be when you made the investment. It is obviously unfair that the government should tax you on that portion of your gains that has actually been eaten away by inflation.
This unfair system of taxation continued till 1993, but now the government allows you to adjust your capital gains for inflation by applying an appropriate factor from Cost Inflation Index to the original price of units.
At the current rate of inflation, long-term gains made over a period—slightly longer than one year, but less than two years—generally don't benefit from indexation. However, there is a way of getting higher indexation benefit than is the case, usually by timing an investment properly. The inflation index for each year is applicable to investments that you hold on till March 31 that year. This means that if you buy an asset on or before March 31 and sell it on April 1 the next year, you will get the benefit of two years' indexation even though you have held the investment for 367 days, i.e, just over one year. Even for longer investments you can always get indexation benefit for one extra year by following this.
Q. How do you calculate tax on capital gains?
Short-term capital gains are subject to normal rates as applicable to other types of income. Long-term capital gains, however, are calculated after applying indexation and then taxed at 20 per cent. Further, in case of long-term capital gains on transfer of publicly-traded stocks and fund units, you have to first calculate tax as mentioned above. If the tax so calculated exceeds the amount arrived at by calculating capital gains tax— 10 per cent without indexation—then the excess has to be ignored.
Let's say that you have invested Rs 1 lakh in a mutual fund on March 30, 2001 and redeemed these units at Rs 1.2 lakh on April 1, 2002. According to the Cost Inflation Index levels announced by the government every year the cost of acquisition would be deemed to be Rs 1,09,901. Your long-term capital gain on this transaction is just Rs 9,901. The tax liability thus would be Rs 1,980.