The word indexation is commonly used when we talk about capital gain taxation on property, gold or debt In other words indexation is used to calculate the taxation on the capital gains/appreciation earned by selling capital assets other than equity. Thus if a bond is invested in for its fixed interest than it's not a capital asset, but when it is invested in to earn profit by trading it in stock market than it is a capital asset. Common capital assets include Equity shares/mutual funds, Debt Mutual funds, Real estate, Gold. Whatever gain or loss comes out of selling these capital assets are termed as Capital gain/loss. The role of indexation comes in when there's long term capital gain on capital assets other than equity.

What is indexation and how it works?

Basically indexation is a process of adjustment of cost/purchase price of capital assets with Cost Inflation index. Through Indexation government allows the investor to adjust the effect of inflation on the gains made on selling of property/asset purchased. In other words indexation helps in knowing that how much return has actually been eaten up by inflation and government reduces your tax burden on that part. This way the gain earned gets reduced by the inflation adjustment which helps in tax saving. The effect of inflation is measured through cost inflation index number which is notified by government for every financial year.

Let's understand Indexation with an example:

Ajay purchased a Residential house in Feb'2003 for Rs 10 lakh and sold the same house in Oct' 2012 for Rs 40 lakh. What would be the taxable capital gain in this case?

Solution:

Purchase date: Feb'03 (FY 2002-03) – CII is 447

Sale date: Oct'12 (FY 2012-13) – CII is 852

Total capital gain: Sale price – purchase price i.e. Rs 40 lakh- Rs 10 lakh = Rs 30 lakh

Taxable capital gain: Sale price – Indexed purchase price i.e. Rs 40 lakh – Rs 19.06 lakh = Rs 20.94 lakh

Indexed purchase price = Purchase price / CII for Purchase year*(CII for sale year)

=40 lakh / 447*(852) = 19.06 lakh

This way you can very well see that after indexation the taxable gain gets reduced by around 9 lakh. Thus the tax levy would be on Rs 20.94 lakh rather than on Rs 30 lakh.

Some important points to understand related to indexation:

1. Indexation applies only in case of Long term capital gains and that too on non-equity or equity related assets.
2. The definition of long term varies in different assets like in case of debt products the long term starts after the holding period of 1 year but in case of physical gold and real estate the condition of holding period is 3 years.
3. The tax rate also varies with different capital assets for instance indexation is compulsory on real estate long term transaction , but in case of debt investments one has an option to pay 10% tax without indexation or 20% tax after indexation.

Concept of double or triple indexation:

The concept of double or triple indexation is used mostly in case of Debt investments the holding of which crosses 2 or more financial year. When one's investment holding period crosses 2 / 3 financial year then it gets eligible to take the indexation benefit for each year. Let's understand this with another example.

Ajay invested Rs 10 lakh in debt mutual fund in Feb'2009 and sold all units in May'2010 for Rs 11.50 lakh. Calculate the taxable capital gain in this case.

Solution:

Purchase date: Feb'09 (FY 2008-09) – CII is 582

Sale date: May'10 (FY 2010-11) – CII is 711

Taxable capital gain: Sale price – Indexed purchase price i.e. Rs 11.5 lakh – Rs 12.21 lakh = (Rs 71k)

In the above example the actual holding period of investment is 1 year and 4 months, but the investment took benefit of 2 financial year's indexation. This way ajay took benefit of double indexation. Generally AMCs launch 13 / 14 months FMPs in feb/march every year and market double indexation feature to sell its product.

Indexation and direct Tax code:

In the proposed direct tax code there's a provision to make changes in the definition of long term and short term capital gains. Unlike today , where the long term starts after holding period of 12 months from the date of investment, the DTC says that the gain will be called as long term only if it is held for a period of at least 1 year after the completion of financial year in which the investment is made. For e.g. Investment made in April'13 will come under long term only after 1 year starting from 31^st march'14 (end of FY 2013-14 in which investment is made) . In this case one year will start from 1^st April'14 and completes on 31^st march '15.

This will not affect the indexation calculation as one will get the indexation benefit but the holding period in debt investments will certainly increase. Moreover as this is just a proposal today, let's see how DTC going to be implemented going forward.