How double indexation benefit helps in reducing tax outgo

I have earlier written one article on Indexation with special mention to Capital gain tax on property transactions. This time I would like to highlight the concept of Double indexation with reference to capital gain taxes on Debt Mutual funds. The concept of double indexation helps in considerable reduction of tax outgo.  January to march months are appropriate months to take maximum benefit of the same. I would encourage my readers to go through the earlier article ( How indexation helps in saving capital gains tax)to have better understanding.

Indexation term is associated with capital gain taxes. Double indexation is nothing but taking the indexation benefit of 2 financial years in one go. In simple terms indexation means adjusting the cost of capital asset (like Mutual funds) with inflation index numbers as per the Cost Inflation index figures announced every financial year. The Indian income tax law has allowed capital Assets to be indexed for calculating long term capital gain tax.  Your period of holding of capital assets decides the long and short term status of your investments. For e.g. Physical gold and Real estate gets the long term status when the period of holding of asset is more than 3 years (36 Months), whereas financial capital assets like Mutual funds, shares, bonds becomes long term after the holding period of more than 1 year ( 12 months).

Indexation is something which is related specifically to financial year (April- March). If an asset is sold after completing the tenure required to gain Long term status as mentioned above, then to calculate the indexed cost of investment, the completion of different financial years also taken into account. Let’s understand this concept with an example.

Date of Investment in debt mutual fund: 1/1/2012 (FY 2012-13)

Completion of one year (12 months) : 31/12/2012

If the investor sell out the above mentioned investment after 31/12/2012 and before 1/4/2013, then he can take advantage of indexation , but if he sell out after 1/4/2013 then he can enjoy double indexation benefit as investment holding has now entered in next financial year ( FY 2013-14).

Lets have a detailed example :

Mr A has invested Rs 100000 in a Fixed maturity Plan on 1/1/2012, which will mature on 15/4/2013 with an expected return of 9% p.a. Now technically the holding period is 1 year 3months and 14 days, but as the holding has crossed 2 financial year, so investment will be indexed 2 times and thus double indexation will be applied here.

Cost (Rs) – Rs 1,00,000 (1/1/2012)

CII (Cost Inflation figure) FY 2011-12 – 785

CII (Cost Inflation figure) FY 2013-14 –939

Indexed cost of investment  would be : Rs 1,19,617 ( Rs 1,00,000/785*(939))

What’s the benefit of indexation / Double Indexation?

Before coming to the benefit of double indexation let me explain you the tax structure of debt mutual funds:

• Any Short term capital gain in debt funds will be added in the investors’ income and taxed as per the income tax slabs one falls into.
• Any Long term capital gain tax in debt funds will be taxed as 10% of the actual long term capital gain or 20% of the indexed capital gain (Selling price minus indexed cost), whichever is less.

Indexation or double indexation helps in considerable reduction of tax outgo, by inflating the cost of investment and thus reducing the actual gains booked. Going back to the above example:

The maturity value (tentative) of the Investment is Rs 1,11,500/-. Thus the absolute gain in this transaction is Rs 11,500/- . To calculate tax on this gain as the holding is for long term so indexation has to be done, and this particular case is of double indexation. The indexed cost as calculated above  is Rs 1,19,617/- . So there is no gain but indexed loss of Rs (-8117)/-.

Thus Tax calculation would be as follows : 10% on Rs 11500/- or 20% on Rs (-8117/-) whichever is less, means ZERO.

Imagining the above investments in a bank deposit, you can assume the quantum of tax you would have been subjected to pay. As the bank deposits’ interest is taxed as per tax slabs, so the payout will be huge as compared to Debt Mutual funds. (Read : Bank deposits Vs debt Mutual funds, which is better)

Since the concept of indexation applies in capital assets and debt mutual funds are very much comparable to bank deposits which are 100% taxable. So by diverting savings from bank deposits and investing in Debt mutual funds one may reduce the considerable tax outgo. Moreover by investing in the end of a financial year i.e in Jan-Mar and withdrawing the funds or getting the maturity proceeds after April next year, one can take the advantage of double indexation also.

These days you will find many Fixed maturity plans coming with double indexation benefit, check out with your adviser to make the most of this opportunity.