What does ‘Indexation’ mean?



Before we get started lets understand....

  • 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.

Income Tax laws have a provision of reducing the effective tax burden on long term capital gains that you earn.

  • 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:


Inflation Index for year in which asset is sold
CII = ---------------------------------------------------------------------
         Inflation Index for year in which asset was bought

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.

For Example

  • An asset was purchased in FY 1996-97 for Rs. 2.50 lacs
  • This asset was sold in FY 2004-05 for Rs. 4.50 lacs
  • Cost Inflation Index in 1996-97 was 305
  • Cost Inflation Index in 2004-05 was 480

So, indexed cost of acquisition would be:

480
Rs. 2.50,000 X ----------------------- = Rs. 3,93,443
305
  • Selling Price of an asset - Indexed Cost = Capital Gains

    i.e. 4,50,000 - Rs. 3,93,443 = Rs. 56,557
    Therefore tax payable will be 20% of Rs. 56,557 which comes to Rs. 11,311 Had it not been for indexation:
    Capital Gains tax would have been as follows:

  • Selling Price of an asset - Indexed Cost = Capital Gains
  • i.e. 4,50,000 - Rs. 2,50,000 = Rs. 2,00,000
    Therefore, tax payable @ 10% of Rs. 2,00,000 would have come to Rs. 20,000.
    So you benefit by saving Rs. 8,689 in taxes by using indexation!!

***The above is only for illustration purposes only.

What – Indexation means adjusting the cost of capital asset by incorporating the impact of inflation during the period of holding i.e. the period between the purchase date and the date of transfer/sale.

Why-This helps to encounter erosion of value in the price of an asset and brings the value of an asset at par with the prevailing market price.

When- This cost inflation index factor is notified by the government every year.

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