Inflation eats into your return on invetsments. Indexation is a process that allows to inflate the purchase price of the asset to take into account the impact of inflation. Indexation considers the inflation from the time you invested in the asset till the time you sell it. Government uses Cost Inflation Index (CII) for the purpose of inflation. CII measures 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.
How indexation helps to reduce tax outgo?
Once the purchase price of the scheme is inflated, the capital gains on selling the scheme reduces for taxation purposes. And lower capital gains means lower tax liability.
Here’s an example:
Assume you invested ₹50,000 in a debt mutual fund scheme in June 2013 and after three years, your investment has gone up to ₹68,000. You redeemed your investments in July 2016. According to plain calculation, ₹18,000 is your long term capital gains on the investment. But, for taxation purposes, you can avail indexation benefit as follows:
CII for 2013-14: 220
CII for 2016-17: 264
Now apply the basic unitary method formula to inflate the purchase price as : 50,000*264/220 = ₹60,000
So, the inflated purchase price is ₹60,000.
For taxation purpose, the capital gains after providing for indexation become ₹68,000- ₹60,000= ₹8,000.
Indexation technique has reduced the capital gains from ₹18,000 ( actual gains) to ₹8,000( gains for tax purpose). And lower capital gains means you have to pay lower tax.
CII values are available on the website of Income tax of India.
Long term capital gains in debt mutual funds units held for more than 36 months are taxed at 20% after indexation benefit.