What Is Indexation?

Did you watch the Budget 2024 news and follow the subsequent mixed opinions from investors on the removal of indexation on long term capital gains tax, wondering all the while what the whole hullaballoo was about?

Indexation, simply speaking, is the adjustment of the price of an asset for inflation for tax purposes. It is a powerful tool in any savvy investor’s arsenal. If you understand how indexation works, you can streamline your investment returns and minimize your tax burden.

What is Indexation and how does it work?

Let’s understand indexation and how it makes taxation fairer by taking an example.

Imagine you bought a stock for some amount X. After a few years, the stock price increases to Y. So, on paper, you’ll make a profit from the amount (Y-X) if you decide to sell the stock. However, you’ll have to pay a tax on your profit called the capital gains tax.

But wait! During those years, inflation has also increased. Considering this fact, you’re dismayed that the tax on the profit (Y-X) is unfair. Here comes indexation. Indexation adjusts the purchase cost of an asset, in this case of your stock, to account for inflation. This adjusted purchase price is called the indexed purchase price. The tax is levied only on the profit obtained after this adjustment. 

To summarise, indexation determines whether the profit you earn on selling an asset is the actual profit when inflation is taken into account. Indexation is particularly useful for long-term investments and can result in significant tax savings by maintaining the purchasing power of your returns relative to inflation.

What are the Types of Indexation?

The different types of indexation in the context of investments and taxation are as follows:

1. Capital gain indexation

This is commonly used when calculating capital gains on long-term investment assets such as stocks, bonds, real estate, and some mutual funds. When capital gains indexation is applied, the purchase cost of the asset in consideration is reduced based on inflation, thereby reducing the taxable amount.

2. Income indexation

The core principle of indexation is preserving purchasing power, whether it be in capital gains or income. Income indexation is the type of indexation applicable to income. Governments and private entities use indexation to adjust salaries and benefits in accordance with inflation.

3. Expense indexation

Businesses employ expense indexation to adjust the cost of various business expenses to determine the effect of inflation.

What is the Indexation Chart?

Tax authorities publish a table called the indexation chart of the cost inflation indexation (CII) chart. This table provides the inflation adjustment factors for that particular financial year. Using the values in this chart, you can calculate the indexed for inflation purchase cost of your assets and evaluate the applicable capital gains tax. To use the indexation chart, follow the steps given here:

• Step 1: Identify the year your asset was purchased. Remember, the year here is not the general year but the financial year. 
• Step 2: Next, determine the financial year of the asset’s sale. 
• Step 3: Use the cost inflation index chart for the financial years determined in steps 1 and 2 and note down the respective CII values.
• Step 4: Apply the indexed cost formula discussed in the next section.

How to Determine the Indexed Cost?

The formula for calculating the indexed cost of an asset is as follows:

Indexed cost = (CII of the year of asset purchase/CII of the year of asset sale) X Original purchase cost

To calculate the indexed cost using the above formula and obtain the capital gains tax, follow these easy steps:

• Step 1: Plug in the values of the CII of the purchase year and sale year calculated in the previous section.
• Step 2: Plug in the original purchase cost of the asset, including the transaction charges.
• Step 3: Solve the formula to determine the indexed cost of your asset. 
• Step 4: Use the current capital gains tax rate to determine the capital gains tax on your sale. The type of asset will decide the tax rate.

What are the Benefits of Indexation?

Indexation provides several benefits to investors. These include:

1. Tax savings

Cost indexation lowers the actual capital tax gains by adjusting the purchase cost of an asset, leading to lower taxes.

2. Maintains purchasing power

With inflation, the actual value of your investments goes down over time. Indexation ensures that your investments’ purchasing power is maintained.

3. Encourages long-term investing

Indexation benefits are significant for long-term investments. This encourages the investors to hold their assets longer. 

What are some strategies to maximize Indexation benefits?

The following strategies can help maximize the benefits of indexation:

1. Long-term holdings

Long-term investments are especially conducive to indexation benefits, which become substantial over time as cost adjustment becomes more significant.

2. Asset allocation

Another strategy to maximize indexation benefits is prudent asset allocation. You can minimize your tax burden by including assets eligible for indexation in your portfolio.

3. Sales timing

You can maximize your tax benefits by timing the sale of your assets eligible for indexation during higher inflation periods. This is because, during these periods, you can get maximum cost adjustment. 

4. Effectively utilizing CII

The tax authorities publish the CII chart annually. Understanding and utilizing the CII charts can help you determine the sales timing of your assets to obtain substantial tax savings.

Conclusion

Now you understand how indexation can be used as an investment tool to maximize investment returns and minimize tax burden. The indexed purchase cost of any asset can be easily calculated using the standard government-published indexation charts. To take full advantage of indexation, you can consider long-term investments such as real estate, stocks or debt mutual funds. 

If you are looking for a reputed and reliable financial institution to help with your long-term investment needs, whether taking a home loan or investing in mutual funds, look no further than Tata Capital. Tata Capital, one of India’s leading Non-Banking Financial Institutions (NBFC), has decades of experience helping over a million individuals turn their dreams into reality. 

To learn more, check the Tata Capital website or download the app.