Indexation is the process that takes into account inflation from the time you bought the asset to the time you sell it. The way it works is that it allows you to inflate the purchase price of the asset to take into account the impact of inflation. The end result is that you get the benefit of lowering your tax liability.
Here are 5 terms to understand about indexation that will give complete clarity on how it works.
1) Inflation
Inflation erodes the value of the asset over time. Let’s say that you have Rs 5,000 as of today. Over 5 years, assuming an annual rate of inflation of 5%, its actual value would drop to Rs 3,868.
It is precisely for this reason that inflation is taken into account when computing tax on the difference between the buy and sell cost.
Of course, that is just one aspect of it. Inflation also eats into the returns from the investment. For example, let’s assume you open a 2-year fixed deposit earning 9% per annum. Should inflation move from 5% to 7%, the effective yield decreases by 2%. Take taxes into account and the result is even more dismal.
2) Capital gains
When you sell an asset, you often make a profit on it. This can be any asset - property, stocks, bonds, mutual funds, art, gold, and so on and so forth. This profit is known as capital gains. It is further split into long-term and short-term capital gains.
If you sell the asset after holding it for a period of 36 months, it qualifies as long-term capital gains. In the case of stocks and equity mutual funds, the holding period to qualify for long-term capital gains is just 12 months.
If you sell the asset before this period, then it qualifies for short-term capital gains.
3) CII
The Cost Inflation Index, or CII, is an inflation index tool used to measure the rate of inflation in the economy. The value of the index is determined by the central government and is increased every year to reflect inflation. With FY1981-82 as the base (CII=100), it was fixed at 939 for FY2013-14.
4) Indexed cost of acquisition
To arrive at this, one has to take the CII for the year in which the asset is sold and divide it by the CII for the year in which it was bought.
So let’s say you bought an asset in 1996-97 (CII = 305) and sold it in 2004-05 (CII = 480). That would amount to 1.5737.
This is now multiplied by the cost of acquisition to arrive at the indexed cost of acquisition.
So let’s assume you bought it for Rs 2 lakh and sold it for Rs 4 lakh. Hence 2,00,000 x 1.573 would amount to Rs 3,14,740. This is your indexed cost of acquisition.
Capital gains would now equal to the indexed price being subtracted from the selling price of the asset: Rs 4,00,000-Rs 3,14,740 = Rs 85,260.
5) Capital gains tax
Let’s continue with the above example. If you just blindly deduct the cost price from the sale price (Rs 4 lakh – Rs 2 lakh), you would land up with a capital gain of Rs 2 lakh. However, that is incorrect since you need to take inflation into account. Once you do so (by following the process detailed above), the capital gain narrows down to Rs 85,260 (Rs 4 lakh – Rs 3,14,740). Hence the amount on which you eventually pay tax is considerably lessened.
The tax paid on this capital gain is referred to as capital gains tax and at 20% with indexation it will be calculated as 20% of Rs 85,246.
