Mutual fund indexation is the process of adjusting the cost of acquisition for inflation to reduce the tax outgo. Read this post to learn more.

There was a major change in the taxation rules from 1 April 2023 onwards by Finance Act, 2023.

Before 1 April 2023, for the purpose of taxation, the Indian mutual fund universe is basically divided into fund categories- Equity Oriented Fund and Funds other than Equity Oriented Fund

1. Equity Oriented Fund- Schemes with at least 65% of the portfolio in Equity shares of domestic company listed on recognised stock exchange

2. Funds other than Equity Oriented Funds- Schemes with less than 65% exposure in Equity shares of domestic company listed on recognised stock exchange

Note – These categories are mentioned for understanding of taxation.

Let’s take a detailed look at what is indexation in mutual funds, how it is calculated, changes to Long Term Capital Gains (LTCG) tax rules from 2023, and more-

Indexation Definition

Indexation refers to modifying a price, or any other value in accordance with changes in another price or a composite indicator of prices. Indexation is used to make adjustments in the purchase price of an investment to reflect the effect of inflation on it. With the help of indexation, you can index (adjust or inflate) the cost of the acquisition of an asset over a period of time to bring it to the current prices after considering the impact of inflation. Indexation is done using a Price Index and this price index is adjusted for indexation. It is adjusted for indexation at the time of buying and selling an asset.

What is Indexation in Mutual Funds?

Redemption or sale of Investments in mutual funds create capital gains. Capital gains can be either long-term or short-term depending upon the holding period. The taxation component depends upon the type of mutual fund. and date of purchase. On investments before 1 April 2023, Indexation benefit was applicable for capital gains generated in mutual funds other than Equity oriented Funds .

When it comes to taxation of Funds other than Equity oriented Funds before 1 April 2023, you generate STCG (Short-Term Capital Gains) if the holding period is less than 36 months. If the investment is held for 36 months or more, you generate LTCG (Long-Term Capital Gains).

STCG from such Funds is added to the investor's taxable income and is taxed as per their tax slab. On the other hand, LTCG is taxed at 20% but used to come with indexation tax benefits. With indexation, the cost of acquiring or purchasing units of the debt scheme used to be adjusted for inflation to reduce the tax liability.

How Was Indexation Calculated?

The CII (Cost of Inflation Index) was used for adjusting the purchase price in the case of LTCG from funds other than Equity oriented Funds. The Finance Ministry releases CII figures for every financial year. Here are the steps to calculate adjusted LTCG

1. The CII of the year when the units were sold was divided by the CII of the year when they were purchased and multiplied by the initial purchase cost.

2. 2. The adjusted cost was deducted from the selling price and multiplied by the total number of units to calculate the LTCG.

Source - https://incometaxindia.gov.in/charts%20%20tables/cost-inflation-index.htm

Example of Indexation Benefit

Mr Akash invested ₹40,000 to purchase 2,000 units of a debt scheme (less than 65% exposure in equity shares) in 2015-16 at ₹20. In 2021-22, the units were sold at ₹30. The investment was held for more than 36 months, so LTCG tax with indexation benefit will apply. Here’s how-

* CII figures taken from the Income Tax India website

So, after adjusting for inflation, the LTCG he generates will be ₹10,080. 20% tax will be applicable on this amount. Without the indexation benefit, the LTCG would’ve been ₹20,000, leading to a higher tax liability.

Note – The above example is only used for representation purpose.

Taxation of Debt Funds After Budget 2023

From 1st April 2023, the tax rules for certain debt funds have changed. Schemes where equity investment does not exceed 35% of the total portfolio shall not be eligible for the indexation benefit and shall be considered as short-term capital gains irrespective of the holding period. Hence, there is an extra category from 1 April 2023; Funds other than Equity oriented Mutual Funds are bifurcated further. Mutual Funds can be bifurcated into following categories from 1 April 2023:

1. Equity Oriented Fund- Schemes with at least 65% of the portfolio in Equity shares of domestic company listed on recognised stock exchange

2. Specified Mutual Fund- Maximum 35% of the portfolio in Equity shares of domestic company listed on recognised stock exchange

3. Other Mutual Funds (not specifically defined)- Schemes with exposure above 35% but below 65% in Equity shares of domestic company listed on recognised stock exchange.

However, indexation benefits shall continue to be available from investments before 1 April 2023. The concept of indexation shall be applicable as follows:

1. Purchases before 1 April 2023- Indexation benefit available to Specified Mutual Funds and Other Mutual Funds.

2. Purchases on or after 1 April 2023- Indexation benefit available only to Other Mutual Funds.

Capital gains from Specified Mutual Funds purchases on or after 1 April 2023 shall not be eligible for the indexation benefit and be considered as short-term capital gains (STCG) irrespective of the holding period.

Source - https://www.livemint.com/news/india/new-mutual-fund-rules-getting-applicable-from-1-april-2023-check-details-11679629222434.html

Other Tax Advantages of Debt Mutual Funds

The indexation on mutual funds was one of the top reasons many investors chose debt funds over other traditionally popular options like bank FDstraditional saving instruments. But even though the indexation benefit is no longer available, debt schemes still offer valuable tax benefits. Take a look-

• Deferred Tax

  With investment options like traditional saving instruments, the interest is taxed on an accrued basis. In other words, the interest is generally taxed annually, and banks deduct the applicable Tax deducted at source (TDS.) But with debt funds, you get the benefit of deferred tax as the tax is only paid at the time of redemption.

• Setting Off Losses

  Debt funds also allow investors to offset their losses against the gains they generate from the investment to reduce their taxable income and tax liability. You can set off STCL (Short-Term Capital Losses) against STCG and LTCG in the future financial years for the same.

Should You Invest in Debt Mutual Funds Even Without the Indexation Benefit?

With or without the indexation benefit, debt mutual funds remain one of the most popular investment options, especially among risk-averse investors with short to medium-term objectives. As discussed above, debt funds still offer significant tax advantages over investment options like traditional saving instruments, even without the indexation benefit.

Discuss your financial goals with an investment advisor who can help you build a diversified mutual fund portfolio.

Mutual Fund investments are subject to market risks, read all scheme related documents carefully.