What is Indexation and How Does It Impact Investment Returns?

Indexation can be defined as a method using which the price of an asset or investment is adjusted in order to factor in the impact of inflation. This adjustment is done mathematically using a cost index chart or indexation chart. Post the adjustment of purchase price via indexation, the taxable returns of the investment decrease, leading to a reduction in the tax liability accrued for the investment. This reduction in tax liability leads to higher net returns for the investor.

The indexation chart or Cost Inflation Index (CII), is a metric used to calculate the annual increase in the price of products or assets due to inflation. The central government updates this cost inflation index chart on an annual basis to account for the annual rate of inflation. The government gazette then publishes the indexation chart. The Cost Inflation Index Chart is included in Section 48 of the Income Tax Act of India, 1961. Below is the CII chart applicable for FY 22-23 (AY 23-24) using the current base year FY 2001-02:

As you can see from the above indexation chart, for the base year (currently FY 2001-02), the index set at 100. As a result of inflation, this index value increases with the passage of time. The data in the above chart can be used to calculate the indexed cost of an investment, which we will discuss next.

To get a clear understanding of how indexed cost of acquisition is calculated, let’s take a simple example. Suppose you purchase a plot of land in FY 2004-05 for Rs. 10 lakh and sell the plot in FY 2020-21 for Rs. 30 lakh. So the total profit you get from the transaction is Rs. 20 lakh.

However, you actually do not need to pay tax on the entire Rs. 20 lakh of gains due to the indexation benefit. To find the actual taxable returns, you can use the indexation chart and find the indexed cost of acquisition. So the formula is:

Indexed Cost of Acquisition = Actual Cost of Acquisition x (CII for year of sale / CII for year of purchase)

As per the indexation chart, the CII (Cost Inflation Index) for FY 2004-05 is 113 and CII for FY 2020-21 is 301. The indexed cost of acquisition in FY 2020-21 for the plot of land bought in FY 2004-05 will be:

Indexed Cost of Plot of land = (Rs. 10 lakh) x (301/113) = Rs. 26.64 lakh

So, net taxable profit after indexation = Rs. 30 lakh – Rs. 26.64 lakh = Rs. 3.36 lakh

So, the applicable rate of capital gains tax will be applicable on net profit of Rs. 3.36 instead of the total profit of Rs. 20 lakh. This will bring down your tax liability significantly resulting in higher net returns from your investment.

The primary benefit of indexation is that it helps investors determine the fair market value of their investment. By factoring in inflation and rising cost of acquisition of the investment, the investor is able to reduce the tax liability resulting from long-term capital gains. Under current indexation rules, only certain long-term capital gains such as property can be used to avail the benefit of indexation.

Earlier debt mutual funds and debt-oriented hybrid funds also featured the benefit of indexation on long term gains if scheme units were held for 3 years or longer prior to redemption. As of April 1, 2023, debt-oriented mutual fund schemes no longer feature the benefit of indexation. However, any debt fund units purchased on or before 31 March, 2023 will continue to benefit from indexation provided they are held for 3 years or longer prior to redemption.

Many markets and economies have widespread indexation regulations and procedures. Most of the time, price adjustment clauses in private contracts result from widespread inflation. When it comes to matters of public debt, taxation, public tariff settings, and other institutional arrangements, governments occasionally play a significant role in pushing the use of indexation.

Although indexation-related techniques are standard in most modern economies, there is still considerable disagreement over this subject. On the one hand, indexation facilitates economic agreements and contracts between private agents under high and even under moderate inflation from a microeconomic point of view. The system of relative prices can withstand significant inflation shocks in particular thanks to indexation.

Indexing wages and other financial benefits is an excellent example of a plan that achieves this goal. In nations where inflation is at least moderate, wage indexation eliminates the need for regular wage negotiations and may lead to lower labour market transaction costs.

Additionally, the success of building liquid long-term fixed-income markets may depend on indexing financial instruments, as evidenced by the experience of various emerging economies. However, indexation also affects the macroeconomic environment. In many stabilization measures, indexation has in particular, been crucial.

The idea of indexation makes investing in debt mutual funds profitable since it gives investors a chance to obtain post-tax returns that are marginally higher. This is because indexation, by employing the Cost of Inflation Index, considerably reduces capital gains and can be used as a way to save income tax.

The ability to gain from indexation had earlier led many investors to stay invested in debt-oriented mutual funds for the long-term i.e. that is 3 years or longer. Now that this benefit is no longer available, some investors are expected to start to moving away from these mutual fund schemes and opt for other long-term debt-oriented investments like bonds, public provident fund, fixed deposits and recurring deposits. However, the benefit of indexation is still applicable on real estate investments even though its derivatives like Real Estate Investment Trusts (REITs) do not offer the benefit of indexation.