How to Calculate Tax Liability in Debt Mutual Funds with Indexation
Credit: North Loop
About Debt Mutual Funds -
A debt fund is a mutual fund scheme that invests in fixed income instruments such as money-market instruments, Corporate and Government Bonds, corporate debt securities etc. Debt funds have a low-cost structure and provide relatively stable returns along with high liquidity. That is the reason they have become popular among investors looking for low-risk options other than bank deposits. The main advantage of debt funds is their ability to provide capital appreciation which is the increase in the value of the investment leading to profits.
Another reason why debt funds are preferred is because of their indexation benefits. An indexation benefit allows compensation for inflation and therefore, cushions you against inflation risk. That means when you sell your fund on a later date, indexation benefits take into account the effect of inflation and reflect the real value of your purchase which in turn leads to lower taxes on the net gain (the difference between your purchase and sale price).
Another reason why debt funds are preferred is because of their indexation benefits. An indexation benefit allows compensation for inflation and therefore, cushions you against inflation risk. That means when you sell your fund on a later date, indexation benefits take into account the effect of inflation and reflect the real value of your purchase which in turn leads to lower taxes on the net gain (the difference between your purchase and sale price).
Taxations of debt mutual funds in India -
Earlier, even though all forms of income through debt funds were subject to taxation as per the Income Tax Act of India, the tax liability on dividend returns of such funds was paid by the asset management company themselves instead of the investors. However, in the Union Budget 2020, the finance ministry changed the mutual fund’s dividend tax rules in India. It is now taxable in the hands of investors. Therefore, fund houses no more need to pay the Dividend Distribution Tax (DDT) on debt mutual funds (or equity mutual funds).
Profits made through the purchase and sale of NAV units in the stock market are chargeable for tax purposes. If you sell your mutual fund investment within three years, tax on debt mutual funds will be as per the income-tax slab rate applicable to you. However, if you sell it after three years, it gets taxed at 20% with indexation benefits.
Profits made through the purchase and sale of NAV units in the stock market are chargeable for tax purposes. If you sell your mutual fund investment within three years, tax on debt mutual funds will be as per the income-tax slab rate applicable to you. However, if you sell it after three years, it gets taxed at 20% with indexation benefits.
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Indexation calculation for tax on debt mutual funds -
The Central Board of Direct Taxes (CBDT) declares a cost inflation index every year that gets used to adjust the value of the capital gains and helps in calculating the real value of profits. The indexation formula used to do so is as follows –
Actual value of profit (after indexation) = Cost of purchase * (CII of the year of selling/ CII of the year of purchase)
Let us now look at taxation of debt mutual funds in India with an example –
Suppose Ms Jain purchased debt mutual funds of 5000 units at Rs.23 in the Financial Year 2012-13 and later sells it at Rs.36 in the Financial Year 2019-2020. As the units got held for more than 36 months, it qualifies for indexation benefit.
The profit realized in the above transaction without any indexation will be 5000 (36-23) = Rs.65000
Let us now arrive at the inflation-adjusted price and applicable tax –
Inflation-adjusted Purchase Price: (289/200)*23 = 33.235 (For Cost Inflation Index refer to the table below)
Now we calculate the LTCG (long-term capital gain) for the same:
5000 x (Rs.36 – Rs.33.235) = Rs.13825
Therefore, the tax calculation for this example will be:
Applicable tax of 20% on Rs.13825 = Rs.2765
Actual value of profit (after indexation) = Cost of purchase * (CII of the year of selling/ CII of the year of purchase)
Let us now look at taxation of debt mutual funds in India with an example –
Suppose Ms Jain purchased debt mutual funds of 5000 units at Rs.23 in the Financial Year 2012-13 and later sells it at Rs.36 in the Financial Year 2019-2020. As the units got held for more than 36 months, it qualifies for indexation benefit.
The profit realized in the above transaction without any indexation will be 5000 (36-23) = Rs.65000
Let us now arrive at the inflation-adjusted price and applicable tax –
Inflation-adjusted Purchase Price: (289/200)*23 = 33.235 (For Cost Inflation Index refer to the table below)
Now we calculate the LTCG (long-term capital gain) for the same:
5000 x (Rs.36 – Rs.33.235) = Rs.13825
Therefore, the tax calculation for this example will be:
Applicable tax of 20% on Rs.13825 = Rs.2765
Example illustrated through table -
| Sale Consideration | 5000 * 36 | Rs.180000 |
|---|---|---|
| Cost of purchase | 5000 * 23 | Rs.115000 |
| Net Gain (without indexation) | 5000 * (36-23) | Rs.65000 |
| Indexed Cost of purchase (CII for the year 2019-120 / CII for the year 2012-13) * Cost of Purchase | 5000*23*289/200 | Rs.166175 |
| Net Gain (With Indexation) | Rs.13825 | |
| Rate of Tax | 20% | |
| Long Term Capital Gain tax (without indexation benefit) | 65000*20% | Rs.13000 |
| Long Term Capital Gain tax (with indexation benefit) | 13825*20% | Rs.2765 |
| Tax saving due to Indexation | 13000 – 2765 | Rs.10235 |
As you can see in the above example, indexation helps in reducing the long-term capital gains by using the CII that ultimately lowers the taxable income. As it provides you with an opportunity to increase the purchase price of your asset, it can reduce the adverse impact caused by inflation on the original cost. That is the primary reason index-linked instruments like debt mutual funds get chosen over conventional investments. The multiple benefits they offer when calculating tax for mutual funds along with yielding profitable returns makes them a popular investment choice.
Cost inflation index value (CII) -
The Cost Inflation Index Value or CII gets determined by the Central Government and is updated on the Income Tax Department’s website every year.
The table of the inflation rate from the year 2009- 2020 is as follows - >
| Year | CII |
|---|---|
| 2009-2010 | 148 |
| 2010-2011 | 167 |
| 2011-2012 | 184 |
| 2012-2013 | 200 |
| 2013-2014 | 220 |
| 2014-2015 | 240 |
| 2015-2016 | 254 |
| 2016-2017 | 264 |
| 2017-2018 | 272 |
| 2018-2019 | 280 |
| 2019-2020 | 289 |
Conclusion -
You can invest in debt mutual funds based on your risk appetite and long-term financial goals. To invest in mutual funds from the comfort of your home, you can sign up on our app. We, at North Loop, offer a variety of mutual fund investment options. You can invest directly or take the help of our mutual fund advisors.
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This publication is provided for general information purposes only and is not intended to cover every aspect of the topics with which it deals. It is not intended be advice. You must obtain professional advice before taking, or refraining from, any action on the basis of the content in this publication. The information in this publication does not constitute legal, tax, investment or other professional advice from North Loop or its affiliates. We make no representations, warranties or guarantees, whether express or implied, that the content in the publication is accurate, complete or up to date. All opinions expressed do not reflect the views of North Loop nor are endorsed by North Loop.
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