Indexation is a technique to adjust tax payments by employing a price index which adjusts for inflation.
Or, in other words, 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.
Inflation erodes the value of the asset over time. Take Rs 5,000. Over 5 years, assuming an annual rate of inflation of 5 per cent, its actual value would drop to Rs 3,868. This impact of inflation over the value of an asset cannot be ignored. Hence it must be taken into account when computing tax on the difference between the buy and sell cost.
It is for this reason that the government uses the Cost Inflation Index, or CII. This 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 1081 for FY2015-16. The CII for every single financial year can be viewed on the Income Tax Department's website.
Let's look at an example.
Asset bought in 1996-97 (CII = 305) for Rs 2 lakh.
Asset sold in 2004-05 (CII = 480) for Rs 4 lakh.
To arrive at the indexed cost of acquisition one has to follow two steps.
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. In this case 480 divided by 305. This would be 1.5737.
This is now multiplied by the cost of acquisition (2,00,000 x 1.573) to arrive at the indexed cost of acquisition (Rs 3,14,740).
Capital gains would now equal to the indexed price being subtracted from the selling price of the asset: Rs 4,00,000 minus Rs 3,14,740 = Rs 85,260.
When you sell an asset, you (hopefully) 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.
If you just blindly deduct the cost price from the sale price (Rs 4 lakh minus Rs 2 lakh), you would land up with capital gains of Rs 2 lakh. However, that is incorrect since you need to take inflation into account. Once you do so (by following the indexation process detailed above), the capital gains narrows down to Rs 85,260 (Rs 4 lakh minus Rs 3,14,740).
Hence the amount on which you eventually pay tax is considerably lessened.
Photograph: Kyle Steed/Creative Commons