As long-term investors, one thing that takes most of our time in terms of our capital gains is tax planning. We may not like the added burden of the taxes on our returns, but it is the ultimate truth in the investment business, which no real-time investor can escape. So what to do? Well, there are some leverages that we can use for the benefit of our account. Specifically, when it comes to long-term investments like debt funds.
A debt fund is an income-oriented fund with a fixed amount of interest and comparatively lower risk than that equity funds. You can know the complete details about investment in debt funds and their types by clicking on the link provided below:
Now, let us find out what these methods are and how you as an investor can take advantage of them!?
Indexation
One of the most popular methods to increase the tax efficiency on long-term investments is indexation. Indexation plays a vital role in calculating an investor’s gain or loss. It is a smart way to reduce the overall tax liability. This is done by the adjustment of the purchase price of an underlying asset or an investment. Indexation helps a tax planner to realize higher gains as those can be adjusted against the inflation rate of purchase and sales year respectively.
Generally, while using indexation for a long-term investment such as debt funds, the following points must be considered :
- When computing the capital gains on debt funds or such investments, the tax efficiency accounts for a holding period of three years
- All types of debt funds shall be eligible i.e. both open and close-ended,
- Indexation provides leeway in terms of the inflation of your investments.
- This benefit is available only for debt mutual funds and not direct bond investments.
How does Indexation work for Debt Funds?
Indexation is done based on CII i.e. Cost Inflation Index. The CII is declared for each financial year by the Central Board of Direct Taxes, which is a department governed by the Indian ministry of finance. Now for indexation, the purchase cost, also known as the acquisition cost is “indexed” for each such fiscal year that an investor’s funds are invested. Also, the capital gains as for taxation is concerned are then computed as the difference between the sale price or also called redemption price, and the indexed cost of acquisition. This enables the investor to reduce the tax on inflated prices and thus reducing his overall tax burden
Let us understand this with the following illustration:
Let’s assume an investor X has invested in a debt fund in July 2020 with an investment amount of Rs.10,000 and by the sum he could buy the units at a NAV of around Rs.10.
After 3 years, X wishes to redeem his investments in August 2023 at a NAV of around Rs.20. So, when X shall sell these investments, the value of the investments shall be Rs.20,000. While investment is made capital gains shall be Rs.10,000. But, X shall have to pay tax on this whole amount of Rs.10,000
Now, as he’s holding period was 3 years, he can avail the benefit of indexation to reduce the value of his long-term gains.
Let us first calculate the Indexed Cost of Acquisition i.e. ICoA by the following formula:
ICoA = Original cost of acquisition X (CII of the year of sale/CII of year of purchase)
As per the above-mentioned figures, the indexed cost of acquisition shall be Rs.10,947, i.e., (10,000 * 289/264). Taking, CII of 2023 as 289 and CII of 2020 as 264 respectively.
Now, here in place of Rs.10,000, the calculated capital gains shall be Rs.9,053, i.e. (Rs.20,000 – Rs.10,947). Based on this, X’s tax shall be computed on Rs.9,053, which will be equal to Rs.1,810.
This is how investors can avail the benefit of indexation. This formula works best when an investor’s holding period is longer. Now, for instance, with a holding period of 5 years, the capital gain tax calculated on your debt funds can come down to 6-7% from a whopping 20%. This is the art or rather the science of indexation which helps an investor to enhance his long-term earnings by effectively helping him to plan his taxes.
