What is Indexation?
Indexation is the process through which the purchase price of an asset is adjusted to account for inflation over time. It reduces your overall tax liability by adjusting the purchase price.
With respect to taxation, indexation benefits are applicable to unlisted bonds & debentures.
For example:
- Mr Vipin invested Rs. 10 lakhs in an unlisted bond in May 2013.
- In Feb 2021, he redeems this investments for Rs.15 lakhs and makes a capital gain of Rs. 5 lakhs.
- Since the investment was held for more than 3 years, the gain on his investment is categorised as a Long Term Capital Gain (LTCG). Hence, the gain of Rs. 5 lakhs is eligible for indexation.
To find taxable gains after accounting for indexation benefits, the original purchase price is adjusted for inflation using the Cost Inflation Index (CII).
Inflation Adjusted Purchase Price = Purchase Price x (CII of the sale year / CII of the purchase year)
For example:
| Particulars | Amount |
|---|---|
Investment in May 2013 (FY 2013-14) | Rs. 10,00,000 |
CII for FY 2013-14 (Purchase year) | 220 |
Sale Value in Feb 2021 (FY 2020-21) | Rs. 15,00,000 |
CII for FY 2020-21 (Sale Year) | 301 |
| Inflation-adjusted Purchase Price | 10,00,000 x (301/220) = Rs. 13,68,182 |
| Taxable Capital Gains (after indexation) | 15,00,000 - 13,68,182 = Rs. 1,31,818 |
In the case of LTCG on unlisted bonds & debentures, tax liability is computed using two methods. Investors can choose the rate that is more beneficial to them:
- 20% of gains (plus surcharge), with indexation benefits
- 10% of gains (plus surcharge), without indexation benefits
The table below shows the difference between capital gains tax payable by Mr. Vipin with and without indexation benefits:
| Particulars | Without Indexation | With Indexation |
|---|---|---|
| Purchase Price | Rs. 10,00,000 | Rs. 10,00,000 |
| Inflation-adjusted Purchase Price | - | Rs. 13,68,182 |
| Sale Value | Rs. 15,00,000 | Rs. 15,00,000 |
| Capital Gain | Rs. 5,00,000 | Rs. 1,31,818 |
| Applicable Tax Rate | 10% | 20% |
| Tax Liability | Rs. 26,363.6 | Rs. 26,363.6 |
As you can see, Mr Vipin's tax liability is reduced by Rs. 23,636.6 with the benefit of indexation applicable to LTCG on unlisted bonds.
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