Making indexation work to your clients advantage

Dilshad Billimoria of Dilzer Consultants explains the importance and application of indexation in various asset classes.

Before getting into an explanation of indexation, let us look at the definition of a few related things.

Capital Asset: This is an asset that is not easily sold in the regular course of business operations for cash. Examples include land, buildings, and machinery that cannot be quickly converted to cash.

Capital Asset is any asset held by the Income Tax Assessee but does not include:

·         Jewellery, art, or drawings.

·         Any stock in trade held by a business in the course of its day to day operations.

·        Agricultural land which is outside the radius of 8 km of municipal limits and has a population of less than 10000. 

Capital Gain: Any appreciation in the value of an asset from its purchase price is gain. The gain is not realized until the asset is sold.

For e.g., if you have invested Rs 1 lakh in an equity mutual fund and it has appreciated by 10% after 1 year, the gain is said to be unrealized, until the asset is actually sold. Once, the fund is sold, the gains become realized and are subject to tax.

 Capital Gain is of two types:

 ·         Short term: This is an asset that is sold before 36 months. However, if these assets are held for 12 months or less, they also come in the purview of short term capital gains. 

a)     Units of specified mutual funds.

b)    Securities listed on a recognized stock exchange.

c)     Units of Unit Trust of India.

d)    Equity or preference shares held. 

·         Long term: If an asset is sold or transferred after 36 months from the date of acquisition or transfer, or after 12 months, in case of the specified assets listed above, the gain is said to be long term capital gains. 

Computation of tax on short term and long term capital gains:

Tax Applicable:

For Short term capital gains: The tax rate applicable is as per tax slab of the individual.

For Long Term Capital Gains made: The tax rate is the lower of 10% on the gain or 20% on the gain after considering indexed cost of acquisition (This option is applicable for assets listed above as securities) For property, the tax rate is only 20% on the gain with indexation benefits.

I will explain what indexation is, and how it benefits you, in just a bit…

For Short term Capital gains, the Sale consideration is reduced by the following:

a)     Expenditure incurred in transfer of a capital asset.

b)    Cost of Acquisition.

c)     Cost of Improvement.

For e.g., if an equity fund is purchased in June 2012 for Rs 1 lakh and the same is sold in January 2013 for Rs 105000, the gain is Rs 5000 and the period is 6 months, therefore, short term capital gains is applicable. If you have incurred a cost to acquire this mutual fund, like fees paid of say Rs 1000, the computation of tax is as under:

Computation of capital gains 

The tax rate applicable here, as mentioned, is dependent on the tax slab of the individual. If the individual is in the highest tax slab, the tax applicable would be 30%+ surcharge. 

Ignoring the surcharge calculation (since it is subject to frequent change), the tax paid on the above Rs 4000 is Rs 1200. Hence, the net gain after tax is Rs 2800.

For Long term Capital Gains, there is a concept of indexation, which needs to be understood first with inflation.

The value of a rupee today, is not the same as the value tomorrow. The prices of articles keep increasing every year and you need to pay more for every article over the years. This is due to inflation and the rising cost of articles and the subsequent decrease in purchasing power. As the cost of 1 liter of petrol has risen from Rs 20 in the early 1980’s to Rs 79 in 2012, you need to pay 300% more for the same quantity of one liter of petrol.

Therefore, just as you have incurred a higher cost on purchase of petrol, the government has given the benefit of paying lower capital gains tax by incorporating the effect of inflation on your cost.

Indexation is used to counter the eroding effect of an asset over time, by using an index every year, which inflates the cost of acquisition of the asset by a factor called the Cost Inflation Index, which is published by the Government every year.

Below is the cost inflation index for all the years.