Maximising Returns

Indexation

Here is a way to reduce your tax liability to less than even 10 per cent of capital gains if you have a one-year time horizon

You may have heard this a million times that it pays to be a long-term investor, especially when you invest in equity-related products. That's not just because your investment returns are more stable over the long-term. It is also because you pay a lesser tax if you hold on to your investments for more than one year.

Any investment held for more than 12 months is subject to long-term capital gains. The same applies to mutual fund units. When you redeem units, you can choose between paying a flat 10 per cent tax on capital gains, or the rate of 20 per cent after accounting for the indexation benefit.

 

What's indexation benefit and how can it lower your tax outgo? Returns can be divided into two parts: nominal return that is generated by an investment and the real return that is available after accounting for inflation. Indexation benefit is designed to tax the real returns of investors. This is achieved by adjusting the investment so that it rises with the inflation rate.

For example, if the Inflation Index rises by five per cent, investors can claim the same as an increase in their cost of acquiring the asset. This means that the taxable gains of investors would decrease. Therefore, indexation benefits accrue to investors in the form of tax being levied only on the real income of the investors.

Indexation benefits can be built into the units with the help of the following ratio.

Cost of Acquisition * Cost Inflation Index in which the asset is sold to Cost Inflation Index in the year in which the asset was bought

Double indexation gives an investor the advantage of indexing his investment to inflation for two years while remaining invested for a period of slightly more than an year. This can be done if the investor puts in money just before the end of a financial year and withdraws it immediately after the end of the next financial year.

For instance, had an investor put money in a fund on March 29, 2001 (two days before the end of FY on March 31, 2001) and withdrawn it on April 2, 2002 (after the end of FY 2001-2002) he would have got the benefit for two financial years (2000-01 and 2001-02). Thanks to this double indexation benefit, the tax outflow is reduced substantially.

Due to the indexation benefit, your returns on debt funds are more tax efficient than fixed-deposit schemes. Thus a growth plan of mutual funds, where the appreciation in asset value gets cumulated and is thus subject to capital gains tax, can yield better returns than dividend plans of the same schemes especially if you are in the top-income tax bracket.