Indexation in mutual funds - meaning, benefits and more- | North Loop Official Blog
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29 Oct 2020

Indexation in mutual funds - meaning, benefits and more-

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While calculating the returns earned on investments, investors often assume just the returns earned on paper as the final returns, wherein, in reality, investors overlook the returns earned after tax deductions. This is where indexation can be used as a standard calculation tool to reduce tax outgo.
In this article, we uncover key topics like what is indexation, the meaning of indexation, how is indexation calculated, the importance of indexation, etc.

What is indexation?

Before we head into the meaning of indexation, let us first understand the term ‘Inflation’.
Inflation is an increase in the price of goods and services as a result of factors such as the reduction in purchasing power of a country’s currency.

With that in mind, let us now look at the meaning of indexation.

Indexation is a method through which an asset’s current value is adjusted by considering factors such as inflation over a period of time. This helps individuals ascertain the difference in price between the time of acquiring an asset and the time of selling an asset. Indexation is done by primarily taking a “Price Index” into consideration, which helps investors adjust the price of an asset to offset the depreciation of an asset’s value.

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Importance of Indexation-

For example, an asset costing Rs. 1000 this year may cost Rs. 1100 the next year and so on as a result of inflation, meaning that the purchasing power decreases every year. Lower purchase price corresponds to lesser returns, meaning that that tax levied on the returns will effectively be lesser. The reduced tax burden in turn makes debt funds a lucrative investment choice for many investors.

In the context of mutual funds, any returns earned on the sale of an asset/assets are considered as capital gains. Capital gains can be of two types and the tax treatment can differ based on the type of capital gains. They are divided into Long Term Capital Gains and Short Term Capital Gains-

  • Long Term Capital Gains (LTCG) are the type of capital gains earned on the sale of assets after a holding period of 36 months in the case of debt funds and 12 months in the case of equities. Indexation benefit is applicable only on LTCG.

  • Short Term Capital Gains are the type of capital gains earned if the holding period of assets is below 36 months (Debt funds) and 12 months (Equities) and the gains are taxed by adding the same to the income of the investor.

How is indexation calculated?

While calculating indexation, an important index known as the Cost Inflation Index (CII) is considered to arrive at the adjusted purchase price of an asset. CII represents the inflation of a particular year and is issued by the Central Government.

The CII for the last 15 years is as follows-

Financial Year CII
2020-21301
2019-20289
2018-19280
2017-18272
2016-17264
2015-16254
2014-15240
2013-14220
2012-13200
2011-12184
2010-11167
2009-10148
2008-09137
2007-08129
2006-07122
2005-06117


In order to calculate the adjusted cost of the purchase price of a debt fund, we will need to use the following formula-

CII value of the year in which the asset was sold divided by the CII value of the year in which the asset was bought multiplied by the actual purchase price of the asset. This is used to arrive at the adjusted price for calculating the LTCG.

LTCG = Selling Price - Adjusted Price. LTCG is the adjusted amount on which the tax is levied at a rate of 20%.


For Example, an individual buys a debt fund in 2015 for Rs. 10,000 and sells the same after 48 months for a price of Rs. 15,000 in 2019. In that case, the capital gains earned before adjustment would be Rs. 5000, which is what the majority of investors pay tax on.

However, by using indexation, the adjusted cost of the purchase price of a debt fund is as follows-

Adjusted purchase price= (CII in the year of sale/CII in the year of purchase) x Actual Purchase Price

(289/254) x 10,000 = 11,377.952

LTCG = Selling Price - Adjusted Price

= 15,000 - 11,377.952= 3622.048

The amount of Rs. 3622.48 is the adjusted LTCG amount on which the 20% tax can be implied.

So, the tax amount is = 20% x 3622.048= 724.40

Tax Amount when levied on Rs. 5000= Rs. 1000 ( a difference of 275.6).

Bottomline-

Indexation sure does make debt funds a lucrative option, as investors can now enjoy the benefit of reduced tax burdens. However, investors should note that their fund holding funding should exceed 36 months in order to make use of the indexation benefits. North Loop offers mutual funds that are carefully handpicked as per the financial plan and goals of investors. North loop provides round-up investing and an automated set of rules and goals through a secure platform. Sign up now!

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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.