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One of the things that makes debt funds attractive is their tax efficiency. Long-term capital gains (LTCG) earned on debt mutual funds are eligible for indexation benefits before they are taxed. What is indexation benefit and how is it calculated?
LTCG in debt funds
Mutual funds provide returns in the form of dividends and capital gains. The dividend is paid periodically by the mutual fund to its investors from the returns earned. Capital gains are earned when mutual fund units are redeemed by the investor at a price that is higher than the purchase price. The capital gains earned are subject to tax in the hands of the investor. The rate of tax depends upon two factors— whether the capital gain was earned over a short- or long-term period, and whether it is earned from a debt- or equity-oriented scheme. Gains made on investment in debt mutual funds held for more than 36 months is considered LTCG and indexation benefit is available on it.
Indexation is the process of adjusting the purchase price of an investment for inflation. The Cost of Inflation Index (CII) is used to index the cost of acquisition of the mutual fund unit. The CII for each financial year is available on the income-tax website, incometaxindia.gov.in. The purchase price is multiplied by the CII for the year in which the sale is made and divided by the CII for the year in which the purchase was made. The indexed price so arrived at is used to calculate the capital gains on which LTCG tax of 20% plus surcharge of 10% plus education cess of 4% (22.88%) is applicable. If inflation has been high in the period between the purchase and sale of the investment, then the indexed cost of acquisition of the investment will go up, reducing the gains that are liable for taxation. Remember, this adjustment of purchase price is done just for calculating the tax on capital gains and it does not mean that the actual gains or profit you made will stand reduced.
For example, if 1,000 units were purchased in FY14 for ₹15 and sold in the year 2018-19 for ₹22.04, the return will be 8%. The profit made on this transaction is 1000 x (22.04 - 15) or ₹7,040. Since the period of holding is more than 36 months, for the purpose of taxation, the cost of purchase of units is indexed using the CII for the years FY14 (220) and FY19 (280) as ₹15 x 280/220 or ₹19.09. LTCG on which tax will apply is 1000 x (22.04 - 19.09) oe ₹2,949.01 and you are liable to pay a tax of only ₹674.73 (22% of ₹2,949.01) as against of ₹1,610.73 (22.88% of ₹7,040) without indexation.
The indexation benefit gives debt funds an edge over other fixed-income investments such as bank deposits in terms of post-tax returns. The interest income earned on a bank FD is added to the total income and taxed at the income tax slab applicable to the investor. Assume that a similar investment of ₹15,000 was made in a bank FD with the same return of 8% as the mutual fund product mentioned earlier. At the end of five years, the FD has a maturity value of ₹22,040 and the interest component of ₹7,040 (22,040-15,000) will be taxable at the investor’s tax slab rate. Even at the lowest tax bracket of 10%, the investor will pay a tax of ₹805.367 (along with surcharge and cess), which is higher than the tax on the debt fund after indexation.