What does ‘Indexation’ mean?

• If you sell an asset such as bonds, shares, mutual fund units, property etc; you must pay tax on the profit earned from it.
• This profit is called Capital Gains.
• The tax paid on this capital gains is called Capital Gains Tax.
• If you sell the asset after 36 months from the date of purchase (12 months for Equity Shares and Equity Mutual Funds), it is called Long Term Capital Gains.

• This provision allows you to increase the purchase price of the asset that you have sold.
• This reduces the profit gap between purchase price and sale price which in turn reduces the net tax payable as the “tax” is a function of the profit gap.
• The idea behind this provision is inflation, it reduces asset value over a period of time.
• This benefit provided by Income Tax laws is called ‘Indexation’.
• Under Indexation, you are allowed by law to inflate the purchase price of your asset by a government notified inflation factor.
• This factor is called the ‘Cost Inflation Index’, from which the word ‘Indexation’ has been derived.
• This inflation index is used to artificially inflate the purchase price of your asset price so that it reflects its true value in the year of taxation.
• In a way indexation helps to counter erosion of value in the price of an asset and brings the value of an asset at par with prevailing market price.
• This cost inflation index factor is notified by the government every year.



For example : The cost inflation index (CII) is calculated as shown:

This index is then multiplied by the purchase price of the asset to arrive at the inflated price representing the true value of the asset at the time of tax computation.

In case of long-term capital gains, the tax liability is computed using two methods

• with indexation (charged at 20% plus surcharge) and
• without indexation (charged at 10% plus surcharge)

The tax liability will be the lower of the two.