By Shyamali Basu, Senior Vice President & Head – Products & Marketing, HDFC AMC
Most of us hate paying taxes but we all have to pay them nonetheless. While one cannot run away from paying taxes, one can certainly make the most of existing tax provisions and make tax efficient investment decisions.
One such tax efficient provision which investors can consider is the benefit of indexation available while computing long term capital gains on investment in debt mutual fund schemes. Gains made on investment in debt mutual funds held for more than 36 months are considered as Long Term Capital Gains (LTCG).
Indexation is the method by which purchase price of an investment is adjusted for inflation (usually adjusted upwards, unless there is deflation). The Cost of Inflation Index (CII) is used to index the cost of acquisition of the debt mutual fund unit.
Indexed cost = (CII for the year of sale/ CII for the year of purchase) X (Cost of purchase)
For instance, if you had invested Rs 1 lakh in debt mutual fund scheme in Aug?16 and redeemed those units in Oct?19 for say Rs 1.30 lakh, then the indexed cost of acquisition = 289/264 * Rs 1 Lakh = Rs 1,09,469. Consequently your LTCG would be Rs 20,531 and not Rs 30,000 (difference between Redemption value and actual cost)#.
#The calculation in the above illustration is based on assumed figures and does not represent a guarantee of returns.
If inflation has been high during the period between the purchase and sale of the investment, then the indexed cost of acquisition of the investment will be higher, reducing the gains that are liable for taxation. The indexed price so arrived at is used to calculate the capital gains on which LTCG tax of 20 per cent plus surcharge (as applicable) plus education cess of 4 per cent is charged.
Further, the fact that the CII is defined for each financial year, means that one can actually end up getting benefit of 4 indexations while investing for a little over 3 years when one invests towards the end of a financial year. Say for instance, one invests in a debt mutual fund in March 2020 with an investment horizon of around 3 years, redeeming in March 2023 would result in benefiting from 3 indexation adjustments (FY 20-21,FY 21-22,FY 22-23). However, redeeming the same investment one month later in April 2023 would make it eligible for 4 indexation adjustments (FY 20-21, FY 21-22, FY 22-23 and FY 23-24).
In view of this, investors with an investment horizon of around 3 years could consider the prospect of investing in debt mutual funds in March and endeavour to make tax efficient returns by holding the units for a month or two longer than 3 years to benefit from an additional year of indexation and reduce their tax outgo. Generally, Fixed Maturity Plans (FMPs) are launched during Q4 (fourth quarter) of a Financial Year to make the most of an additional year of indexation. However, one can also benefit from this provision by investing in March in open-ended debt schemes for ~ 37 months.
Investors can consider various debt mutual funds with different maturity profiles and credit quality like Short Duration Funds, Medium Duration Funds, Banking and PSU Funds, Corporate Bond Funds and Credit Risk Funds for a period of 3 years and above depending on their risk appetite.
To conclude, it is worth noting that debt funds offer well diversified portfolio as compared to traditional fixed income instruments like FDs etc. and are also more tax efficient compared to them owing to the benefit of indexation. Just like you hunt for discounts during Black Friday Sale, this March, explore the option of investing in Debt Mutual Funds for an investment horizon of 3 years and above to make the most of cost indexation benefit.
Disclaimer: The views expressed are author?s own views and not necessarily those of HDFC Asset Management Company Limited (HDFC AMC). The views are not an investment advice. Investors should obtain their own independent advice before taking a decision to invest in any securities. Mutual Fund investments are more volatile and riskier compared to traditional investment instruments. HDFC Mutual Fund/AMC is not guaranteeing returns on any investments. Investors should be aware that the fiscal rules / tax laws may change and there can be no guarantee that the current tax position may continue indefinitely. In view of individual nature of tax consequences, investors should consult their professional tax advisor.
(Mutual fund investments are subject to market risks, read all scheme related documents carefully.)