Monday, March 28, 2011

Indexation ... Double Indexation

As per the Indian Taxation law , whenever an asset has been held for the long term, "Indexation Benefit" can be availed by the investor when the investor finally sells the asset.

The term "Long Term" is different for different instruments.
  • Stocks and Mutual funds,a period of one(1) year is considered long term
  • House, Property a period of three (3) years is considered long term

When an asset is sold after the above mentioned period , the profits/losses that are made  are called "Long Term Capital Gains/Losses"

In case of Equity there is no Long Term Capital Gains Tax (LTCGT). But in case of other assets like Debt Mutual Funds, Property there is a Long Term Capital Gains Tax to be paid .

Long Term Capital Gains Tax (LTCGT) is computed as
  • 20% of Long Term Capital Gains with Indexation
  • 10% of Long Term Capital Gains without Indexation

What is Indexation ?
Capital gains would be usually calculated as

Capital Gain = Selling Price – Purchase Price

But fortunately government realised this is not a fair assumption because , rise in inflation usually eats into your profits . So in order to compensate for inflation , governments lets you increase your purchase price.

But arbitrary increase of purchase price cannot be allowed , so every year CBDT  (Central Board of Direct Taxes ) comes out with a Index value for Cost Inflation Index (CII). using this Index to reduce the cost of purchase is called Indexation



















How is this index to be used
Capital Gain = Selling Price – Cost Inflation Indexed Purchase Price

How is "Cost Inflation Indexed Purchase Price" calculated
Cost Inflation Indexed Purchase Price = Purchase Price X (CII for current year / CII for year of purchase )

Suppose you bought a 370 day FMP on 28th March 2009 (Financial Year 2008-2009) for Rs. 50,000 and then it was redeemed on 3rd April 2010 ( Financial Year 2010-2011 )  for say Rs.70,000

Then the Cost Price = Rs. 50,000
Cost Inflation Indexed Purchase Price  = 50,000 x ( 721/582 )  = 61,941

Please note: Financial year is considered not the calender year . so thought it was only for a year ( 370 days ) that this money was invested, since this crossed two Financial year ( 2008-2009 to 2010-2011) , we are doing a "Double Indexation" here

So Capital Gain
  • With Indexation  = 70,000 - 61,941 = Rs.8,059
  • Without Indexation = 70,000 - 50,000 = Rs.20,000

Capital Gain Tax would be :
  • 20% with Indexation       = 20%  of  8,058.5 = Rs. 1,611
  • 10 % without Indexation = 10 % of 20,000 = Rs, 2,000
The Income tax payer can choose any of the two options , based on his option to pay less amount of tax.

So, the month of March each year see a heavy offerings of 370 days FMP by mutual funds to let investors take advantage of "Double Indexation".

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