# Indexation: Introduction, Meaning & Calculation

by Angel One

Capital market investment is subject to tax under the current tax regime, and it is proportionate to your capital gain from investments. That is, higher is your gain, higher is the tax amount. However, if you don’t apply indexation, it may increase your total tax liability manifold.

Indexation is a technique of adjusting the purchase power of an asset against inflation to reduce the total tax burden on investment.

In this blog, we will look into what is indexation and how it helps in managing your tax liabilities better. Indexation, the word translates to ‘suchikaran’ in Hindi, is a process of keeping a list of all captital gains or losses against assets. By definition, it is an economic regulation process that attaches wage and interest with the cost of living index.

### Highlights

• – Indexation means adjusting price, wage, or other values based on another or against an index like CPI (consumer price index)
• – Indexation is calculated to accommodate the effects of inflation, cost of living, and asset price over time to adjust different prices over different timeframes and geographical areas
• – It is also used to calculate wage increase to match it with inflation to maintain the purchasing power of consumers
• – Measures gains and losses of an investment, especially long-term investments like debt funds and other assets
• – It allows investors to maintain profitability on their investments even after paying taxes

## Understanding capital gain

Discussion on indexation revolves around capital gain, but how to measure it. Capital gain refers to the profit from selling any asset, either tangible or intangible.

Under the current tax regime, any investment with tenure of more than 36 months is considered a long-term investment. Conversely,  an investment of  12 months duration or less, is called short-term investment. A fixed-rate of 20 percent tax is levied on long-term investments with indexation. On the other hand, investors need to pay according to their income tax slab on short-term capital gains.

## How To Calculate Capital Gains With Indexation

Above, where we have discussed what indexation is, we have mentioned that it is an efficient way to prevent capital gains getting drained by taxes. It helps to reduce your overall tax liabilities by adjusting the purchasing price of an underlying for investment.

Indexation helps with adjusting capital gain tax on your long-term investment. As asset price appreciates, it brings less profit and hence, less tax. To calculate indexation, the rate of inflation is obtained from the Cost Inflation Index (CII), which the central government publishes in the income tax department’s website.

Indexation is the reason that debt funds are considered a better investment choice than traditional investment tools like fixed deposit, which doesn’t adjust to inflation and provide a fixed income under any economic condition.

Let’s consider this with an example. Suppose you had invested Rs 10000 in 2017 at a NAV (Net Asset Value) of Rs 10. After three years when you want to redeem the funds, your investment value appreciates to Rs 20,000, and NAV stands at Rs 20. Hence, your capital gain from the investment is Rs 10,000. As per capital gain tax laws, you can avail the benefit of indexation since you had invested for three years. But, how can indexation help in lowering your tax burden?

To understand that we would need to measure the Indexed Cost of Acquisition (ICoA).

ICoA= Original cost of acquisition x (CII of the year of sale/CII of year of purchase)

So, in the example discussed above,

ICoA= 10,000* (289/272) or, 10,625

So, your final capital gain is Rs. 9375 (20,000-10,625) and you can avoid paying any tax on Rs 625 of capital gain.  Tax will be calculated on only Rs 9375, at the rate of 20 percent.

Indexation helps you to save more tax if you stay invested for a longer period. For five year tenure, the tax rate on debt funds further reduces to 6-7 percent.

Similarly, we can calculate the same for mutual funds too.

Let’s assume you had invested in 6000 units for Rs 23 five years ago in 2015. In 2020, the NAV value has increased to Rs 36. Since you have remained invested for more than three years, you can apply indexation to adjust for capital gain tax.

ICoA = 23*(289/254) = 26.17

Long-term capital gain or LTGC without indexation = 6000*(36-23) = 78,000

LTGC with indexation = 6000*(36-26.17) = 58,980

## Computing Indexation on Equity and Equity MFs

In tax rate modification proposed in the budget of 2018-19 LTCG on equity shares is subject to a capital gain tax of 10 percent without indexation for any investment of more than one year.

To apply indexation on equity shares, investors need to calculate the actual cost of acquisition on it.  It is calculated by arriving at the lowest of the asset and highest cost of the asset based on the fair market value of the underlying. Let’s elaborate with an example.

Equity is acquired on Jan 2017 at Rs 100. On January 31 in 2018, it’s fair market value is say Rs 200. Now, in May 2018 the equity is sold on the market for Rs 225. So, the cost of acquisition of CoA is Rs 25 (225-200).

Different scenarios can arise while calculating the actual cost of acquisition under different market scenarios. However, according to sub-clause (5) of clause 31 of the Finance Bill 2018, it is clarified that inflation indexation benefit wouldn’t apply in calculating CoA for long-term capital gains under the new tax regime.

However, investment upto Rs 1.5 lakh in certain notified equity-linked saving schemes is allowed under section 80/c. But, these are subject to lock-in of 3 years, where every SIP is calculated as a separate investment and holding period gets readjusted with each SIP date.