Capital Gains and Indexation

Capital Gains and Indexation

What is Capital Gain: If you sell an asset such as bonds, shares, mutual fund units, property etc; you must pay tax on the profit earned from it. This profit is called Capital Gains. The tax paid on these capital gains is called capital Gains tax. Conversely, if you make a loss on sale of assets, you incur a capital loss

Types of Capital Gains

Short Term capital Gains: If you sell the asset within 36 months from the date of purchase (12 months for shares and mutual funds).

Long Term Capital Gains: If you sell the asset after 36 months from the date of purchase (12 months for shares and mutual funds).

Benefits From Capital Gains Tax

·         Income Tax laws have a provision of reducing the effective tax burden on long term capital gains that you earn.

·         This provision allows you to increase the purchase price of the asset that you have sold.

·         This helps to reduce the net taxable profit allowing you to pay lower capital gains tax.

·         The idea behind this is inflation – since we know inflation reduces asset value over a period of time.

·         This benefit provided by Income Tax laws is called ‘Indexation’.

What is Indexation?

Under Indexation, you are allowed by law to inflate the cost of your asset by a government notified inflation factor. This factor is called the ‘Cost Inflation Index’, from which the word ‘Indexation’ has been derived. This inflation index is used to artificially inflate your asset price.  This helps to counter erosion of value in the price of an asset and brings the value of an asset at par with prevailing market price. This cost inflation index factor is notified by the government every year. This index gradually increases every year due to inflation.

How is cost-inflation index computed?

The cost inflation index (CII) is calculated as shown:

         Inflation Index for year in which asset is sold

CII =  --------------------------------------------------------------

         Inflation Index for year in which asset was bought

This index is then multiplied by the cost of the asset to arrive at inflated cost.

For example

An asset was purchased in FY 1996-97 for Rs.2.50 lacs

This asset was sold in FY 2004-05 for Rs.4.50 lacs

Cost Inflation Index in 1996-97 was 305 and in 2004-05 it was 480

So, indexed cost of acquisition would be:

                                    480

         Rs.250000  x    -----    = Rs.3,93,443

                                    305

Long Term Capital Gains would be calculated as:-

Capital Gains = Selling Price of an asset –   Indexed Cost

i.e. Rs.450000 – Rs.393443 = Rs.56557

Therefore tax payable will be 20% of Rs.56557 which comes to Rs.11311.

Capital Gains tax would have been as follows:-

Capital Gains = Selling Price of an asset –   Cost of acquisition 

i.e. Rs.450000 – Rs.250000 = Rs.200,000

Therefore tax payable @ 10% of Rs.200000 would have come to Rs.20,000

So you save Rs. 8,689 in taxes by using the benefit of indexation

At the rate of 10% with indexation

OR

At the rate of 20% without indexation

Therefore, you need to ascertain which of the two methods would yield lower tax incidence on your capital gains.