Between 2009 and 2015, consumer inflation was very high, which offered tax bonuses for investors. Suppose an investor bought a property in 2009-10 for Rs 100. He sold it after five years in 2014-15 for Rs 147, which was compounded annually. Return of 8%. But though his investment made a profit of Rs 47, he did not have to pay any tax. This is because indexation has pushed up the purchase cost by Rs 162. Instead of paying tax, the investor actually recorded a loss of Rs 15 and adjusted that loss against other capital gains. “Index leverage is a very useful tool for investors. It can be especially beneficial during periods of high inflation,” says Sudhir Kaushik, CEO of tax filing portal TaxSpanner.
Cut to 2021-22, when inflation is at its peak once again. The only difference is that this time consumer inflation is not as high as it was in 2009-14. Consumer inflation has been decidedly low over the years, falling below 4.7 per cent in the last five years. As a result, the Cost Inflation Index (CII), the number used to calculate indexation, has also moved at a slower pace during this period. The CII is announced by the government every year and is around 75% of the consumer inflation rate. Indexed cost can be calculated by the formula given above.
Suppose the investor from the earlier example bought another property for Rs 100 in 2016-17. He sold it five years later in 2020-21 for Rs 147, once again earning an annual return of 8%. But this time consumer inflation has been low, so indexation can push up the purchase cost by only Rs 120. So even though there is tension from rising prices, the investor gets only a limited return from indexation. He makes a profit of Rs.27 and has to pay 20% tax on this capital gain. Indexation benefit applies to capital gains from the sale of assets, gold, unlisted stocks and non-equity mutual funds. Listed stocks, equity funds and equity-oriented balanced funds are not eligible for this benefit.
down but not out
Although the indexation benefit has been reduced by current low consumer inflation, it still makes some investments more profitable for investors. For example, this makes debt funds far more attractive than fixed deposits. If the investment has been made for more than three years, then the gains from debt funds are treated as long-term capital gains. These are eligible for indexation and post-indexation gains are taxed at 20%. In comparison, the interest earned on fixed deposits is fully taxable at the marginal rate applicable to the individual. In the 30% tax slab, this significantly reduces the effective return. A fixed deposit that offers 7% return would actually be less than 5% for an investor in that tax slab.
Taxpayers have no option but to reduce the effect of indexation benefit. Till a few years back, the investor had the option of paying a flat tax of 10% without any indexation or 20% tax after indexation. But that option has been removed and taxpayers will now have to mandatorily go for indexation.