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

Posted on 23 Nov 2022 • Updated on: 26 Mar 2023
Author: Sayan Sircar

Tags: Tax ; Mutual Funds

11 mins read
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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

This article is a part of our detailed article series on the concept of mutual fund taxation in India. Ensure you have read the other parts here:

How to calculate and save tax on mutual funds?

This article is expected to give investors in India a complete guide on the topic of calculation of taxes on mutual funds.

What is the biggest benefit of holding mutual fund units in demat form?

This articles discusses some benefits and drawbacks of storing your mutual funds in demat mode with one killer feature that makes transmission possible.

What should debt, international and gold mutual fund investors do now that these funds are taxable at slab rate?

This article shows the way forward for investors in debt, gold, hybrid and international funds which have lost indexation benefits on units purchased after 1st April 2023.

Which mutual fund has lower tax - international funds at 20 percent vs domestic at 10 percent?

This article settles the question of which type of capital gain calculation is better - debt-type funds taxed at 20% with indexation vs equity-type at 10%.

Pay lower capital gains taxes for equity: understand how grandfathering works

This article explains the concept of equity LTCG grandfathering in detail with multiple case studies and examples.

How to calculate taxes from capital gains and combine them with your other income

This article talks about understanding capital gains tax calculations and computing offsets vs other income.

How is tax calculated on selling shares/MFs and how do to do tax harvesting?

This post discusses the concept of tax calculations and tax harvesting in a simple manner.

📚 Topics covered:

What is so special about debt capital gains calculation?
Scope of assets under debt taxation
Calculating short-term capital gains tax on debt-related assets
Calculating long-term capital gains tax on debt-related assets
Using Cost Inflation Index to calculate LTCG
- Cost Inflation Index (CII) table
Smart applications of the benefits of the indexation rule
- Fixed Maturity Plans (FMP)
- International funds

What is so special about debt capital gains calculation?

Note: As per the amendment to the Finance Act 2023, on 24th March 2023, debt mutual funds purchased after 1st Apr 2023 will be taxable at slab rates just like FDs: What should debt, international and gold mutual fund investors do now that these funds are taxable at slab rate?. The points made in this article are valid only for units purchased before 1st April 2023.

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.

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.

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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.

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	%ch
1	2001-02	100	0.00%
2	2002-03	105	5.00%
3	2003-04	109	3.81%
4	2004-05	113	3.67%
5	2005-06	117	3.54%
6	2006-07	122	4.27%
7	2007-08	129	5.74%
8	2008-09	137	6.20%
9	2009-10	148	8.03%
10	2010-11	167	12.84%
11	2011-12	184	10.18%
12	2012-13	200	8.70%
13	2013-14	220	10.00%
14	2014-15	240	9.09%
15	2015-16	254	5.83%
16	2016-17	264	3.94%
17	2017-18	272	3.03%
18	2018-19	280	2.94%
19	2019-20	289	3.21%
20	2020-21	301	4.15%
21	2021-22	317	5.32%
22	2022-23	331	4.42%
23	2023-24	348	5.14%

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.

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?

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