How to Calculate Your Tax Liability in Debt Mutual Funds with Indexation?

If you want to invest in mutual funds, the two main options you have are equity funds or debt funds. Equity funds invest in the stock and are seen as mutual funds that give higher returns but with considerable risks involved. Debt funds, on the other hand, invest in fixed income securities like corporate and government bonds and money market instruments.Debt funds do not give returns as high as equity funds but they have a significantly lower risk factor. This is the reason why many investors looking for a consistent and stable investment that is better than a fixed deposit look towards debt funds as an attractive option.Yet another benefit of debt funds is indexation. We all know the phenomenon of inflation that gradually drops the value of the Rupee. Indexation is something that can help us lower our taxes on debt fund gains using inflation adjusted purchase prices.To understand this clearly, let us first look at how debt fund earnings are taxed.

Income from all forms of debt funds are taxed according to the Income Tax Act of 1963. The responsibility to pay taxes on dividends from debt funds falls on the Asset Management Company and not on the investors directly. The AMC pays Dividend Distribution Tax of 29.12% on the total earnings of debt mutual funds, 25% of which go towards tax payments, 12% towards surcharge, and 4% cess charges.On the other hand, the profits made due to purchase and subsequent sale of NAV units in debt funds are subject to tax liability to the investor. Two types of taxes may be applied here:

1) Short Term Capital Gains Tax:

The tax rate for debt fund profits falls under short term capital gains tax if the security is held by the investor for less than 3 years. The tax applicable in this case will be according to the income tax slab of the investor.

2) Long Term Capital Gains Tax:

If the investment remains for more than 3 years, then long term capital gains tax is applicable. Without indexation, the tax applicable will be according to the income tax slab of the investor. With indexation, however, the tax will be 20% of the earnings.The benefit of indexation is only applicable for debt mutual and no other type of mutual funds.
Whether the investor wants to use the benefit of indexation or pay taxes according to their slab rate is completely their choice.

We just mentioned the benefit of indexation above, but what exactly is indexation? Indexation is a type of benefit that lets you adjust the original purchase price of your NAV units so that your total profit amount is reduced. The LongTerm Capital Gains Tax applicable on this reduced profit will now be lesser, thus reducing your tax liability. Thus, indexation is a tool to reduce your taxes on debt fund earnings by allowing for inflation adjustment.Indexation Calculation for Debt FundsThe Cost Inflation Index is announced by the Central Board of Direct Taxes (CBDT) and is applied to the capital gains in debt funds. The formula used is: Actual purchase value after indexation = original amount * (CII of the current year/CII of the purchasing year.) Let us make this calculation clear with an example.Suppose Mr. A made an investment of Rs. 1 lakh in debt mutual funds in 2014. After a period of four years, in 2018, Mr. A redeems his units for Rs. 1.8 lakh, thus earning a profit of Rs. 80,000.Since the units were held for four years, the profit will be subjected to Long Term Capital Gains Tax.Now Mr. A has two options:

• If he doesn't want to take the benefit of indexation, he will have to pay the tax on his entire profit of Rs. 80,000 profit according to his income slab rate.
• If, however, Mr. Awants to use indexation, his original purchase price would change after taking into account the inflation rate in 2014 and 2018. The CII of India in 2014 was 240, while in 2018 it was 280.

Inflation indexed purchase price = 100,000 * (280/240) = Rs. 1,16,666.67/-Thus, the new profit gained by Mr. Anil will be,

New gains:

Value after redemption - New indexed cost = 1,80,000 - 1,16,666.67 = Rs. 63,333.33According to the tax mutual fund rules for debt funds, after indexation 20% tax applies.So the tax applicable will be = 20/100 * 63,333 = Rs. 12,666.67Therefore, we can see that the tax will be applicable on a smaller amount if indexation is used and that will result in a lower capital gains tax.

Indexation does not necessarily mean that the liable taxes would be lower in all cases. If a person belongs to a lower income tax bracket, the taxes applicable on long term gains on debt funds may or may not be lower than the indexed taxes. Therefore, it is important to calculate how much tax you’re liable to pay with or and without indexation and choose the option where less tax is applicable.

The information contained herein is generic in nature and is meant for educational purposes only. Nothing here is to be construed as an investment or financial or taxation advice nor to be considered as an invitation or solicitation or advertisement for any financial product. Readers are advised to exercise discretion and should seek independent professional advice prior to making any investment decision in relation to any financial product. Aditya Birla Capital Group is not liable for any decision arising out of the use of this information.