How Indexation in Debt Funds reduces Tax Outgo? (With Examples)

When fixed deposit rates are so low that there is nothing to write about, then it’s natural for people to try to look for alternatives to bank FDs. And one very obvious alternative is the debt fund. Debt funds have historically delivered returns better than fixed deposit.

But if there is one major advantage that debt funds have over the fixed deposits, then it’s their taxation. And that too the Indexation benefit that allows debt funds to drastically cut down your tax outgo and improving post-tax returns.

In this post, allow me to explain in detail how exactly indexation works and helps reduce the tax you pay on capital gains. What is indexation benefit in debt funds and how is it calculated? You will have all the answers by the end of this post.

When you invest in debt funds, you are investing for profits – or as is correctly called, capital gains. The said capital gains earned are subject to tax in the hands of the investor.

How much is Capital Gains Tax on Debt Funds?

The rate of tax depends upon whether the capital gain was earned over a short or a long-term period. So as per the latest Debt Fund Taxation Rules (FY 2020-2021):

• Short Term Capital Gains (STCG)– Gains made on investment in Debt Mutual Funds held for less than 3 years (or 36 months). And this Short Term Capital Gains (or STCG) on Debt funds are taxed as per the investor’s income tax slab rate.
• Long Term Capital Gains (LTCG) – Gains made on investment in Debt Mutual Funds held for more than 3 years (or 36 months). And this Long Term Capital Gains (or LTCG) on Debt funds is taxed at 20% with indexation

So that is the short term capital gain tax rate on debt mutual fund and the long term capital gain tax rate on debt mutual funds.

As you may have observed, the short term gains are taxed in a manner similar to the taxation of fixed deposits. That is, as per the investor’s income tax slab rate. So if you redeem your debt fund investments before completion of 3 years, it will get the same treatment as a fixed deposit and you will pay tax on your gains according to your income tax slab rates.

It is the taxation of long-term capital gains (LTCG) that provides indexation benefits for the debt fund investors. The LTCG tax rate on debt mutual funds is 20% but after indexation.

So that is your simple answer to i) what percentage of tax is paid for short term capital gains from debt funds? ii) what percentage of tax is paid for long term capital gains from debt fund without indexation?, and ii) what percentage of tax is paid for long term capital gains from debt fund with indexation?

Now let’s understand more about this indexation option available for taxation of Long Term Capital Gains from debt funds.

Indexation is a way to adjust capital gains as per the prevailing inflation index. So via indexation, the purchase price of an investment is adjusted for inflation (usually upwards). By increasing the purchase cost, the capital gain for tax purposes reduced. And as a result, the actual tax you pay also reduces significantly. You will understand this very clearly when we take a simple example shortly.

Now let’s take a small example to understand this concept.

Suppose you invested Rs 20 lac in a good debt fund in August 2016. After a little more than 4 years, i.e. in October 2020, the value of your debt fund investments has become Rs 28 lac.

Now you plan to sell your debt fund investment at this point.

So mathematically speaking, you made capital gains of Rs 8 lac, i.e. Rs 28 lac – Rs 20 lac. That’s your actual profit.

But this gain was made after a period of 4 years, which is more than 3 years requirement for capital gains qualifying as Long Term Capital Gains for Debt Funds.

So do you pay tax on this full Rs 8 lac gain at the time of selling?

No.

Because as per the latest taxation rules of mutual funds, the Long Term Capital Gains on Debt Mutual Funds are taxed at 20% after indexation. This means you need to adjust the cost of acquisition of debt fund units for indexation first.

But what is the exact criteria for adjusting the cost?

The government regularly releases the Cost of Inflation Index (CII) which is used to index (or adjust) the cost of acquisition of the debt mutual fund units. Using the CII number date, the following are known:

• Cost of acquisition = Rs 20 lac
• CII number for 2016-17, the year of purchase = 264
• CII number for 2020-21, the year of sale = 301

(Read how to use Cost Inflation Index (CII) number for LTCG Indexation Calculation).

So the indexed cost price of acquisition is calculated using the formula:

Indexed Cost = Actual Cost * (CII of Sale Year / CII of Purchase Year)

And in our example, this comes out as follows:

= Rs 20 lac * (301/264) = Rs 22,80,303

And this means that the long term capital gains is calculated as follows:

= Rs 28,00,000 – Rs 22,80,303 = Rs 5,19,697 (~ Rs 5.2 lac)

So you get taxed at 20% on this amount of Rs 5.2 lac (instead of the actual profit of full Rs 8 lac without indexation). And this translates to:

LTCG tax of 20% on Rs 5.2 lac, i.e. Rs 1.04 lac (approx.)

Had it not been for indexation benefit, your tax would have been 20% on full actual profit of Rs 8 lac: 20% of Rs 8 lac = Rs 1.6 lac.

So the Indexation technique has reduced the capital gains from Rs 8 lac to Rs 5.2 lac. And lower capital gains means you have to pay a lower tax.

And how do you look at it at a debt fund NAV level?

The capital gains from debt fund is the difference between your purchase NAV and the NAV at which you sell. And depending on your holding period, you will be taxed as per the gains being long term or short term in nature.

Let’s say you purchased 10,000 units of a debt fund at Rs 10 per unit in 2015. That is you invested Rs 1 lac (= Rs 10 x 10,000 units).

Now you decided to sell all the units in 2019 when the NAV had risen to Rs 15. That is, the value of the investment was Rs 1.5 lac (= Rs 15 x 10,000 units).

So the capital gains at NAV level is Rs 5 (Rs 15 – Rs 10). But if you adjust the cost price of the NAV using CII numbers of 2015-16 (CII – 254) and 2019-20 (CII – 289), then using the formula for the indexed cost price of acquisition, we get:

= Rs 10 NAV * (289/254) = Rs 11.38 NAV – which is your new indexed cost.

Hence the capital gains for taxation purpose at NAV level will be Rs 15 – Rs 11.38 = Rs 3.62 (and not Rs 5 earlier). This automatically reduces your tax outgo.

In summary, the purchase price of debt fund (investment price) is multiplied by the CII for the year in which the sale is made and divided by the CII for the year in which the purchase was made. The indexed price so arrived at is used to calculate the capital gains on which LTCG tax of 20% plus surcharge and cess, etc. are applicable.

The indexation benefit gives debt funds an edge over other fixed-income investments such as bank deposits in terms of the post-tax returns. More so for those in higher tax brackets. Remember that the interest income earned on a bank fixed deposit is added to the total income and taxed at the income tax slab applicable to the depositor. There is no option to reduce tax outgo for bank FDs using indexation.

How to Calculate Capital Gains for your Debt Mutual Funds?

• Find out the date of purchase for your debt fund.
• Find out the date of sale for your debt fund.
• Calculate the number of days (months) you have remained invested in the fund. This will be the difference in the two dates above.
• If the number of months is less than 36, then your profits are called as short-term capital gains. But if its more than 36 months, then it is long-term capital gains and eligible for indexation benefits.
• Subtract the initial investment value from the final sale (redemption) value to ascertain the exact amount of gain.
• If it is short-term capital gain, then your gains will be taxed as per the income tax rate applicable to you.
• If it is long-term capital gain, then first you will adjust the purchase cost for indexation (as described in the above examples using appropriate CII numbers of the financial years of purchase and sale. Then once the cost is adjusted, the revised capital gains figure will be taxed at 20%.

Someone was asking me one day that among various options available in which funds the long term capital gains tax would be payable after adjustment for indexation? The answer is debt funds.

Two interesting points about using CII numbers to reduce your tax outgo via indexation:

• If inflation is high during the period between the purchase and sale, then the indexed cost of acquisition of the investment will be higher. This in turn will reduce the capital gains further. And this will reduce the tax outgo on long term capital gains of debt fund.
• The CII number is defined for each financial year. So that means that if you invest closer to the end of a financial year, you can get the benefit of 4 indexations while investing for just over 3 years. How? Suppose you invest in a debt fund in February 2020 and plan to remain invested for ‘about 3 years’. Now if you redeem the debt fund in April 2023, it will allow you to use 4 indexation adjustments (namely of Financial years 2020-21, 2021-22, 2022-23 and 2023-24). So by holding for 38 months, you get the benefit of one extra year’s indexation. Had you just redeemed in February 2023, that is in exact 36 months, you would have got only 3 years of indexation benefit. So you can time your debt redemptions like this if you want to optimize further.

This is how indexation helps reduce your tax obligations considerably in debt funds. And this is one of the biggest reasons that makes debt funds very attractive for your debt investments.

And let’s not forget that the adjustment of the purchase price in Debt Funds (to accommodate indexation) is done just for calculating (and lowering) the tax on capital gains. It doesn’t actually reduce the actual gains or profit you made on your debt fund investments.

(To know more details about debt fund taxation, do read how debt funds are taxed in India 2020).

When investing in debt funds, investors can consider various options in different debt mutual funds categories that have different maturity profiles and credit qualities. Since we are discussing primarily long term capital gains that are available after 3 years, one can look at investing in Ultra Short Duration funds, Low Duration funds, Short Duration Funds, Money Market Funds, etc. depending on their own risk appetite.

And since all these fund categories come under debt funds, the ultra short term fund taxation, low duration fund taxation, short-duration fund taxation, money market fund taxation are all similar to what we have discussed till now.

Mind you that debt funds are not risk-free. At times (but very rarely), some problems arise with certain debt funds (like this and this). But then, even fixed deposits aren’t risk-free if you know what I mean (read which are safe banks for FD).

But all said and done and comparatively, the risks in debt funds are slightly higher and you need to understand how to pick right debt funds. And also what NOT to expect from debt funds.

Since the indexation benefit is available on debt mutual funds, it makes them more tax-efficient than regular bank Fixed Deposits. Fixed deposits and debt funds are taxed differently. And this gives debt funds a big edge over bank deposits in terms of post-tax returns.

Unlike debt funds where the capital gains are taxed only at the time of sale and that too with indexation benefits, the interest income on bank FDs is added to the total income every year and taxed as per the income tax slab applicable to the depositor.

(To know more details, do read how fixed deposits are taxed in India).

Till now, the debt funds have offered better returns than fixed deposits in recent years. And if that wasn’t a good enough reason, then even from a taxation point of view, the debt funds offer a better choice especially if you are in high tax brackets and can hold debt funds for more than 3 years.

You will see how indexation benefits available to debt funds make them more tax-efficient than FDs and how exactly does the indexation help considerably lower the long-term capital gains on debt mutual funds in India (2020) and gives debt funds an edge over the bank deposits in terms of post-tax returns.