How indexation benefit lowers tax on debt, gold & international mutual funds

Published: June 19, 2020 at 10:50 am

Last Updated on August 22, 2022 at 11:16 pm

According to the income tax rules, the gain from each unit of a non-equity mutual fund that is older than three years is subject to 20% taxation with indexation benefit using the cost inflation index. With the Cost inflation index for FY 2020-21 just announced, let us see how tax is lowered on all debt funds, debt-oriented hybrid funds, gold funds and international equity funds  and when this would be useful.

An equity mutual fund is one that holds “on average” 65% or more of Indian equity (including arbitrage) in a financial year. All other mutual funds are classified as non-equity funds. In the case of equity funds, a one-lakh tax-free limit is available for the total gains from units that are older than one year. Beyond that, a tax of 10% on the gains apply. This can be exploited as shown earlier: Generating tax-free income from arbitrage mutual funds

In the case of non-equity mutual funds, the cost inflation index in the year of purchase and year of redemption is necessary to compute the tax, provided the purchase was made more than three years ago. The Cost inflation index(CII) for FY 2020-21 is 301.  For a purchase made say in May 2017, the relevant CII would be 272 (for FY 2017-2018).

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Take for example the FT US Feeder fund. This is obviously an international equity fund. Over the last 3Y years it has returned about 22%(!).  Rs, 10,000 invest in mid-2017 would now be worth about Rs. 18,000. This is an absolute capital gain of Rs. 8000.

The income tax dept allows us to first increase the purchase price using the CII and then compute the capital gain.  To do this we ask if Rs. 10,000 corresponded to CII = 272, what amount would correspond to CII of 301?

Inflation-adjusted purchase price = 10,000 x 301/272 = 11,066 (approx) or

Inflation-adjusted purchase price = purchase price x CII in the FY of sale/CII in the FY of purchase

Actual capital gain = Rs. 18,000 – Rs. 10,000 = Rs. 8000

Inflation-adjusted capital or indexed capital gain =  Rs. 18,000 – Rs. 11,066 = Rs, 6934.

We need to pay 20% tax + 10% surcharge + cess of 4% = 22.88% on Rs. 6934 instead of Rs. 8000. So a tax of Rs. 1587 is to be paid and the actual post-tax capital gain = Rs. 6413. This means the post-tax annualised return is 18% (approx).

Before you rush to invest in an international (= US) fund, please remember this requires three year holding period and returns can fluctuate quite a bit. If you, “what is the problem a three year holding period?”, then you have a lot to learn about portfolio management and periodic rebalancing (systematic or regular). Of course, it is another matter that people invest in US equity only for returns and not diversification.

In the case of gold, the last 3Y returns were about 16%. Using the above indexation benefit illustration, the post-tax return is about 13.4%.  As for debt funds, a 6% pre-tax liquid fund return would correspond to 5.4% post-tax return. Again, the 3Y holding period does not help in portfolio management.  Note: Sov gold bonds are tax-free if held until maturity but should not be compared with gold funds or ETFs as they are suitable only for a risk-free accumulation of gold and not diversification.

Arbitrage funds may a be bit more tax-efficient, even without considering the Rs. one lakh tax-free limit. Naturally, tax benefits are only secondary to associated risks. That said, being ultra-conservative for more than five years can mean quite a bit of tax (as per slab) and this is where debt mutual funds and arbitrage come in.

Guaranteed returns always come with a price. For just a few years, the price is not too high and the peace of mind is worth it. Over longer durations, when reasonably safe choices are available (say gilt funds), there is no need to hide behind the safety of bank deposits and exclusively hide behind the illiquidity of tax-free provident funds.  Extreme choices come with an extreme price tag. It is possible to find a balance.

As mentioned above, long-term portfolios require rebalancing – either once a year or on 5% or 10% triggers. See: When should I rebalance my portfolio? – this means those who hold international equity funds/ETFs or gold funds/ETFs or debt funds should not rely on this indexation benefit for rebalancing events. It would, however, make a difference wrt the final corpus.

Indexation benefits also work well with debt funds for medium-term goals above three years, below 10 years when equity allocation is small and tax-free provident fund options cannot be typically used.

Sometimes investors want to “experiment” with a small exposure to international or equity funds. This need not be part of the main portfolio and need not be rebalanced. Indexation benefits can make a difference here too.

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