Double indexation benefits

With FMPs losing sheen, opt for products that provide cost inflation advantage.

During March, a large number of investors start scouting for instruments that will provide them with double indexation benefits. The idea is to get better returns by reducing tax liabilities.

The term double indexation benefits is basically providing the advantage of two cost inflation indices to the investor for staying invested in a particular instrument for a particular time period.

The government, in order to determine the exact amount of the rise in the value of the asset, declares a cost inflation index each year. This index figure is based on the inflation rate that was witnessed in the economy during a particular year.

The manner of working of the cost inflation index is such that the cost is raised, depending on the index value in the financial year of purchase and sale of the units. For example if there is an investment of Rs 10,000 in the financial year 2006-07 and sold in the financial year 2008-09, the cost of the investment will go up to Rs 11,214 while calculating the gain or loss. (10,000 X 582 – index in year of sale/ 519 index in year of purchase)

Under the Income Tax Act, whenever there is an asset that is held for the long term, the indexation benefit is available to the investor. The term long term is different for various instruments. For stocks and mutual funds, this is calculated as a holding period of one year while for a house property this period is three years.

The double indexation benefit is best utilised in the month of February and March. This is because these two months provide the best benefit, in terms of the holding period of the investment.

The entire concept of double indexation is based on the fact that the last few months of the financial year provide a natural advantage as far as the holding period is concerned. There is a situation where, if the mutual fund units are held for a period of just 13-14 months, they will generate the benefit of two years of indexation for the investor.

Consider this in case of an investment in March 2009. The month of March falls in the financial year 2008-09. If the investor sells the mutual fund units in April next year, then the holding period for the units will be 13 months. This will ensure that the investment qualifies as a long term investment. Since April 2010 will fall in the financial year 2010-11, the investor will get indexation benefits of 2008-09 and 2009-10.

The real use of this concept is possible each year with debt-oriented mutual funds. As far as equity-oriented mutual fund schemes are concerned, the long term capital gains have a zero tax rate, so the question of claiming indexation benefits does not arise. For debt schemes, this provision exists.

In many cases, especially for the current financial year, it is likely that the actual tax might turn out to be near zero percent. The average return in long term gilt and income schemes is around the 9-10 per cent mark.

Looking at the market situation, the returns in the coming 12-15 months might turn out to be lower than this rate. In the last couple of years, the inflation index has risen by 5.6 per cent and 6.1 per cent respectively and, even if the rise is around 4 per cent in the next two years, around 8.1 per cent returns will be tax-free for the investor.

The actual figure will, however, depend on each individual investment and their exact earnings and returns.

This year, investors will have to rely on debt-oriented scheme units, like income schemes, short-term funds and even gilt schemes to get the benefit. There is, however, one important fact that needs to be kept in mind. Do not rush to invest just for double indexation benefits. Instead, opt for investments that are expected to do well, and let the tax benefits be incidental.

The writer is a certified financial planner