How can cost inflation indexation reduce tax liability?

What is cost inflation indexation and how can it reduce my tax liability on capital gains? How is cost inflation indexation to be calculated? What categories of investments qualify for indexation benefits?

— A Buddhiraja, Salem

If you sell an asset for a price that is higher than what you paid for it, the profit you make is taxable. If the gains are short term, they are clubbed with the owner’s income for the year and taxed at normal rates. But if the gains are long term, they are taxed at a lower rate. The tax department has different minimum holding periods for each asset.

Long-term capital gains from shares and equity funds (where over 60% of the corpus is invested in equities) are tax free. But the gains from the sale of other assets are taxable. The taxpayer has the option to pay either of the following:

A flat rate of 10% of the profits as tax
A 20% tax after cost indexation

Indexation takes into account the inflation during the investment period and accordingly raises the purchase price of the asset. This upward revision of the purchase price is called indexation. The government announces a “cost inflation index” for each financial year. The indexed cost of an asset can be calculated by the following formula:

Purchase price  X  [Cost inflation index in the year of sale / cost inflation index in the year of purchase]

For instance, the cost inflation index in 1994-95 was 259 and in 2003-4 was 463. If you bought a house in July 1994 for Rs 32 lakh and sold it in August 2003 for Rs 64 lakh, the tax payable can be calculated as follows:

SALE PRICE – PURCHASE PRICE = PROFIT

OPTION I

Rs 64 lakh – Rs 32 lakh = Rs 32 lakh

Long-term capital gains tax @ 10% = Rs 3.2 lakh

OPTION II

Purchase price (Rs 32 lakh)  X  [Cost inflation index for 2003-4 (463) / Cost inflation index for 1994-5 (259)]

The indexed purchase price comes to Rs 57.2 lakh

Rs 64 lakh – Rs 57.2 lakh = Rs 6.8 lakh

Long-term capital gains tax @ 20% = Rs 1.36 lakh

A taxpayer can opt for the calculation that suits him. Investors in debt funds use the indexation benefit to the hilt.

If you invest at the end of a financial year (say, March 2007) and redeem 13 months later in April 2009, you would get indexation benefit of two years. In times of high inflation, this can reduce the tax to zero.