All you wanted to know about double indexation benefit

Double indexation simply means getting the benefit of two years of indexation when the holding period for investments has been substantially less than two years. Read on to gain clarity on double indexation.     

What is indexation?

It is adjusting purchase price of an asset to reflect the impact of inflation, primarily for the purpose of calculating capital gains tax. Adjusting purchase price implies scaling it upwards based on the inflation during the period.

Now let’s explore these terms one by one

In very simple terms inflation is price rise. It implies that more money has to be shelled out for the same set of goods. For e.g. the price of 1 kg sugar has increased from around Rs. 20 in 2008 to Rs. 40 in 2012. Inflation reduces the value of money i.e. Rs. 20 was more valuable in 2008 than it is today because today it can buy only half a kg of sugar.

Capital gain essentially means profit on sale of an asset. For e.g. If Mr. X invested Rs.1000 in a mutual fund and sold it for 1200, then Rs. 200 is his capital gain.

Depending upon the duration for which the asset was held with the investor, the capital gains are categorized as short term capital gains and long term capital gains. For equity mutual funds if the units are sold within 1 year of purchase, the return is considered as short term capital gain.  If the units are held for a period exceeding 1 year, the returns are called long term capital gains.

What is the need for indexation?

Apples can’t be compared to oranges. If return on investment has to be calculated then cost price and the selling price should be at the same scale.

Let’s take an example

Mr. ABC invested Rs.1000 in 2008 and sold it for 1500 in 2012. The Rs. 1000 of 2008 has to be increased to reflect the inflation during the year 2008 and 2012, brought to the scale of 2012 and then compared to the Rs. 500 of 2012 to calculate the actual capital gain.

 How is indexation done?

Cost inflation index (CII) numbers are released every year. To adjust cost of purchase of the asset to reflect inflation the index numbers for the year of sale and year of purchase are required.

Let’s take an example

The CII number for 2001-2002 is 426 and for 2011-12 is 785. Mr. ABC invested Rs. 10000 in May 2001 and sold it for Rs. 20000 in July 2011. 

The inflation adjusted cost of purchase is calculated as:

10000 x (785 / 426) =18427 

His actual return for the purpose of taxation with indexation will be (20000-18427) Rs. 1573.

What is double indexation?

To understand the concept of double indexation let’s assume two cases:

A)    If Mr. ABC had bought 10 units of mutual fund for Rs. 10000 on 1^st April 2009 and sold them for 12000 on 1^st April 2010. (Holding period- 1 year).
B)    If Mr. ABC had bought 10 units of mutual fund for Rs. 10000 on 31^st March 2009 and sold them for 12000 on 1^st April 2010. (holding period- 1 year and 1 day)

In the two examples given above, the information is same except the year of purchase, which differs by just one day.

The difference in one day changes the financial yearof purchase for Mr. ABC, which changes the CII numbers to be used for indexation.
 

Case A: Single indexation

Case B: Double Indexation

Mr. ABC’s taxable return (with indexation) varies in the two cases explained above because of the indexation number. His taxable return (with indexation) comes down drastically in Case B which reduces his tax liability (absolute terms) as well.

Mr. ABC can claim indexation for two years but he is actually holding the investment for just a day over 1 year.

Hence double indexation benefit is, enjoying indexation benefit for 2 years when the investment is not held for a substantial part of second year.