Arthgyaan

Supporting everyone's personal finance journey

Pay lower capital gains taxes for debt mutual funds: understand how indexation works

This article shows you how the concept of indexation lowers the capital gains tax you pay when you sell debt mutual funds.

Pay lower capital gains taxes for debt mutual funds: understand how indexation works


23 Nov 2022 - Contact Sayan Sircar
9 mins read

This article shows you how the concept of indexation lowers the capital gains tax you pay when you sell debt mutual funds.

Pay lower capital gains taxes for debt mutual funds: understand how indexation works

Table of Contents

What is so special about debt capital gains calculation?

Long-term capital gains (LTCG) for debt-type assets (like mutual funds holding bonds, non-Indian shares or less than 35% Indian shares) are taxable at 20% as per capital gains tax calculation.

This tax calculation is only on profits with an indexation benefit. Indexation allows you to reduce the profits, on which tax is calculated, by inflation over the period.

This concept of indexation is why debt mutual funds are more tax-efficient than fixed deposits when held longer than three years since the tax you pay is much less compared to FD which are taxed at slab. If we assume inflation to stay high in India as a developing nation, the tax on debt-type assets like debt mutual funds (and international funds) will be very low.

We cover the concept in detail now.

Recent articles:
1 / 3
<p>This article shows a way to decide what to do when stock markets reach all-time or lifetime highs. Should investors buy more or sell to book profits?</p>
The stock market has reached an all-time high. Should you buy or sell?
2 / 3
<p>This article uses the Arthgyaan Have vs Needs Framework to invest a large lump sum amount in your portfolio per your financial goals.</p>
How to invest a lump sum amount for your goals?
3 / 3
<p>This article shows you how the concept of indexation lowers the capital gains tax you pay when you sell debt mutual funds.</p>
Pay lower capital gains taxes for debt mutual funds: understand how indexation works

Scope of assets under debt taxation

Type Portfolio Short-term capital gains | Taxation Long-term capital gains | Taxation
Shares, Equity MF or equity-oriented Hybrid MF >65% Indian equity <365 days | 15% + cess + surcharge >= 365 days | <1 lakh/year is tax free. Gains above 1 lakh are taxed at 10% + cess + surcharge
Debt or Hybrid funds (debt oriented) or International funds <65% Indian equity <3 years | Taxed at slab rate >=3 years | 20% + cess + surcharge on gains post indexation

where, Capital gains = (Selling price - Buying price) * Units sold

We are interested in the second row of the table above and specifically in the bottom right cell on long term capital gains.

We will cover the concept of short-term gains first.

Short-term capital gains arise if the asset is sold only after buying it less than three years ago.

The formula is simple:

CG = MV - BV

where

  • CG = Debt-related capital gains on which tax will be calculated
  • MV = Sale value of the position reduced by transfer costs if any
  • BV = Purchase value of the position

Tax is calculated as:

Tax = SlabRate % * CG

where CG = total debt-related capital gains as per the PAN of the investor across all selling done between 1st Apr to 31st Mar and SlabRate = the highest tax slab of the investor

This tax calculation rule makes it extremely expensive, from a taxation perspective, to sell a debt-type asset within the short-term window. But the real magic starts when the asset is held even a day longer than that.


Goal-based-investing plan

Long-term gains are calculated as:

CG = MV - BV_post_indexation

where BV_post_indexation = (Buying price) * (Cost Inflation index today / Cost Inflation index at the time of purchase).

The Cost inflation index or CII is a number published by the Central Board of Direct Taxes (CBDT) for every financial year that is used to calculate capital gains on selling a capital asset like real estate, mutual funds, stocks or bonds.

The CII figure is published at the beginning of every financial year. It is used to rebase the purchase price of a capital asset, utilising the concept of indexation.

We define the following terms:

  • purchase price or book value (BV): the original price paid at the time of purchase
  • sale price or market value (MV): the sale price of the asset
  • CII in the financial year of purchase (CII0)
  • CII in the financial year of sale (CII1)

Indexed purchase price = BV * CII1 / CII0

Capital Gains = MV - Indexed purchase price

Since CII1 > CII0, Indexed purchase price > BV, meaning that the capital gains, and hence the capital gains tax you pay, is lower due to indexation.

Using Cost Inflation Index to calculate LTCG

Cost Inflation Index (CII) table

Serial # Financial Year CII
1 2001-02 100
2 2002-03 105
3 2003-04 109
4 2004-05 113
5 2005-06 117
6 2006-07 122
7 2007-08 129
8 2008-09 137
9 2009-10 148
10 2010-11 167
11 2011-12 184
12 2012-13 200
13 2013-14 220
14 2014-15 240
15 2015-16 254
16 2016-17 264
17 2017-18 272
18 2018-19 280
19 2019-20 289
20 2020-21 301
21 2021-22 317
22 2022-23 331

Download as CSV

Always refer to the latest CII table from here for the calculation of LTCG.

We take the example of a debt mutual fund purchased in 2015 and sold in 2020

  • CII at purchase is 254, CII at sale time is 301
  • The purchase value is ₹10,000
  • The sale value is ₹15,000
  • Indexed purchase price is ₹10,000 * (301/254) = ₹11,850
  • LTCG = ₹15,000 - ₹11,850 = ₹3,150

Here we see that the LTCG is lower than the simple profit of ₹5,000 due to the indexation benefit.

If you are interested in understanding how the 20% indexation rule fares vs. the 10% taxation rule for equities, read this: Which mutual fund has lower tax - international funds at 20 percent vs domestic at 10 percent?.

Smart applications of the benefits of the indexation rule

Fixed Maturity Plans (FMP)

FMPs are closed-ended debt funds that are typically released for a holding period of just more than three years to take advantage of the indexation benefit. Sometimes these funds open in March and mature in April just three years later. Here even if the holding period is of three years, the indexation benefit comes from four financial years:

  • close for subscription on 25 Mar 2023
  • mature on 10 Apr 2026
  • indexation benefit applicable for FY 2022-23, 2023-24, 2024-25, and 2025-26 i.e. for four years

Disclaimer: FMPs are complex and have a fair amount of risk that is not there in open-ended (“normal”) debt mutual funds. These concepts will be covered in detail in a future article.

Rebalancing in March and April

Since CII goes up with time, it makes sense to buy debt-taxed funds as early as possible and sell them as late as possible to take advantage of this tax calculation.

In general, assets with indexation benefit on the purchase price, irrespective of appreciation, will lead to lower taxes the longer they are held. Of course, you should not keep capital blocked solely to have the benefit of indexation but a bit of planning is important.

If you are rebalancing annually, it makes sense to do it in March/April. The following thumb rules can be used to time purchases and redemptions for rebalancing and harvesting:

  • sell equity-taxed funds and buy debt-taxed funds sometime before 31-Mar
  • buy equity-taxed funds and sell debt-taxed funds just after 1-Apr

You get one extra year of indexation benefit in both cases for debt-type funds.

Given that AMCs allot new MF units only on realisation of incoming funds from the investor, investors who do not have large amounts of cash handy for such trades, can use the daily SPP facility of MFUIndia to perform such switch trades. They can do this by slowly selling out of the old fund, wait for the money to come and then enter the new fund with that redeemed cash to eliminate the risk of the markets moving abruptly while they are waiting for the AMC to allocate new units.

International funds

International funds, since they don’t hold more than 65% Indian stocks, are taxed using this indexation rule. Combining that with the rebalancing rule above, we can perform tax-efficient rebalancing in March and April. We have a study on the benefit of 20% tax post indexation and 10% tax on Indian equities here: Which mutual fund has lower tax - international funds at 20 percent vs domestic at 10 percent?

If you liked this article, consider subscribing to new posts by email by filling the form below.

Worked out case studies for goal-based investing

Previous and next articles:

<p>This article lets you calculate if you should break your old FD and create a new one at higher interest rates after adjusting for premature breakage penalty.</p>
Calculator
Should you break your FD and create a new one at new higher rates?

This article lets you calculate if you should break your old FD and create a new one at higher interest rates after adjusting for premature breakage penalty.

Published: 20 November 2022

8 MIN READ


<p>This article uses the Arthgyaan Have vs Needs Framework to invest a large lump sum amount in your portfolio per your financial goals.</p>
Portfolio Construction Mutual Funds
How to invest a lump sum amount for your goals?

This article uses the Arthgyaan Have vs Needs Framework to invest a large lump sum amount in your portfolio per your financial goals.

Published: 27 November 2022

5 MIN READ


Latest articles:

<p>This article shows the effect of postponing early retirement by just a little since it allows you to spend more in retirement.</p>
FIRE
FIRE journey in India: what happens if you work just a bit longer

This article shows the effect of postponing early retirement by just a little since it allows you to spend more in retirement.

Published: 4 December 2022

2 MIN READ


<p>This article shows a way to decide what to do when stock markets reach all-time or lifetime highs. Should investors buy more or sell to book profits?</p>
Market Movements
The stock market has reached an all-time high. Should you buy or sell?

This article shows a way to decide what to do when stock markets reach all-time or lifetime highs. Should investors buy more or sell to book profits?

Published: 30 November 2022

4 MIN READ


Topics you will like:

Asset Allocation (17) Basics (8) Behaviour (10) Budgeting (9) Calculator (13) Case Study (3) Children (9) Choosing Investments (28) FAQ (3) FIRE (10) Gold (6) Health Insurance (4) House Purchase (13) Insurance (12) International Investing (8) Life Stages (2) Loans (10) Market Movements (8) Mutual Funds (14) NPS (5) NRI (4) News (5) Pension (6) Portfolio Construction (36) Portfolio Review (22) Retirement (29) Review (7) Risk (6) Safe Withdrawal Rate (5) Set Goals (26) Step by step (8) Tax (16)

Next steps:

1. Email me with any questions.

2. Use our goal-based investing template to prepare a financial plan for yourself
OR
use this quick and fast online calculator to find out the SIP amount and asset allocation for your goals.

Don't forget to share this article on WhatsApp or Twitter or post this to Facebook.

Discuss this post with us via Facebook or get regular bite-sized updates on Twitter.

More posts...

Disclaimer: Content on this site is for educational purpose only and is not financial advice. Nothing on this site should be construed as an offer or recommendation to buy/sell any financial product or service. Please consult a registered investment advisor before making any investments.

This post titled Pay lower capital gains taxes for debt mutual funds: understand how indexation works first appeared on 23 Nov 2022 at https://arthgyaan.com


We are currently at 206 posts and growing fast. Search this site:
Copyright © 2021-2022 Arthgyaan.com. All rights reserved.