In the recent past, Fixed Maturity Plans (FMPs) have emerged as popular investment avenues for investors in the debt funds segment. It is common for fund houses to use factors like the "virtually" assured yield (rate of return) and defined investment horizon to attract investors.
Another pitch that routinely features in the sales literature, especially in the period before the close of the financial year (31st March) is the double indexation benefit. In this article, we demystify double indexation.
Whenever a capital asset like a mutual fund scheme or a property, among other assets is sold, it could lead to a capital gains tax liability. The liability can either be short-term or long-term, depending on the tenure of investment. For example, in the case of mutual funds, an investment held for a period of more than 365 days qualifies as a long-term investment.
In case of long-term capital gains, the tax liability is computed using two methods i.e. 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.
Simply put, indexation means adjusting the cost of the capital asset (in this case a mutual fund), 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. An example will help us better understand the same.
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Say an investor Mr. A purchases units of a Monthly Income Plan (MIP) on April 1, 2005; he buys 1,000 units at Rs 10.00 each. He decides to sell his entire holding on April 1, 2006; on the date of sale, the net asset value (NAV) of each unit is Rs 10.90. While computing his tax-liability, Mr. A needs to compute the gains using both the methods i.e. with indexation and without indexation. In the latter, the capital gains amount to Rs 900 (Rs 10,900 less Rs 10,000).
Conversely, for computing the capital gains taking into account the indexation benefits, the Cost Inflation Index (CII) needs to be factored in. The CII for the year of purchase i.e. 2005-06 is 497, while that for the year of sale i.e. 2006-07 is 519.
The indexed cost of purchase is computed as follows:
(Cost of purchase X CII - year of sale)/(CII - year of purchase)
How indexation works
| Cost of purchase (I) | Rs 10,000 |
| Sale proceeds (II) | Rs 10,900 |
| CII - Year of purchase | 497 |
| CII - Year of sale | 519 |
| Indexed cost of purchase (III) | Rs 10,443 |
| Capital gains (with indexation) (II - III) | Rs 457 |
| Capital gains (without indexation) (II - I) | Rs 900 |
| Tax liability (with indexation) | Rs 104 |
| Tax liability (without indexation) | Rs 102 |
As can be seen in the table above, the capital gains, after factoring in indexation amounts to Rs 457 vis-à-vis Rs 900
Double indexation
Double indexation means enjoying indexation benefits for more than one financial year, without having to hold the asset for the said period. Simply put, an investor can claim indexation benefits for 2 financial years, without having been invested for 2 financial years.
For example, in the case above, if Mr. A were to make his investment a day earlier i.e. on March 31, 2005, the financial year for purchase would be 2004-05. Let us assume that date of sale is unchanged i.e. April 1, 2006 (financial year 2006-07). Effectively Mr. A's investments would have been held only for an extra day; yet for the purpose of computing capital gains, indexation benefits can be claimed for 2 financial years. The capital gains would be computed as follows,
How double indexation works
| Cost of purchase (I) | Rs 10,000 |
| Sale proceeds (II) | Rs 10,900 |
| CII - Year of purchase | 480 |
| CII - Year of sale | 519 |
| Indexed cost of purchase (III) | Rs 10,812 |
| Capital gains (with indexation) (II - III) | Rs 88 |
| Capital gains (without indexation) (II - I) | Rs 900 |
| Tax liability (with indexation) | Rs 20 |
| Tax liability (without indexation) | Rs 102 |
On account of being invested for an additional day (vis-à-vis the previous scenario), the capital gains after factoring in indexation amount to Rs 88. The same is significantly lower than Rs 457 in the previous scenario. Likewise, the tax liability of Rs 20 (double indexation) is lower vis-à-vis Rs 104 (indexation for 1 year) as well.
Our advice -- while double indexation can aid investors "rationalise" their tax liability, it should never be the sole reason for investing in an investment avenue.
For example, while investing in an FMP, factors like the yield being offered, the investment horizon and the quality of investments, among other factors should be considered. Factors like double indexation should be treated as ancillary benefits at best.
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