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Tuesday, May 7, 2013

Double Indexation Benefit on Debt Funds

Many investors park their surplus fund in fixed maturity plans (FMPs) and other debt funds in March every year to take advantage of the double indexation benefit and to bring down (and almost eliminate) the tax liability on returns.

The Trick
Investors can take advantage of double indexation by investing in March of year 1 (let us say FY 2012-13) and then selling in April of year 3 (FY 2014-15). Note that you are investing for effectively 13 months but you get the indexation benefit for 2 years because of the timing of your investment.
This virtually brings down the tax impact to a very low level if not to zilch. In some cases, you can even show a capital loss (although you have made a gain). This means whole yield on such investments becomes tax free.

How does double indexation work?
Double indexation would kick in if you invest in the end of the first financial year and sell in the beginning of the third financial year. So if you invest in March 2013 (financial year 2012-13) and sell your investment in April 2014 (financial year 2014-2015), you can get the benefit of double indexation. This may help you to reduce your income tax liability on long-term capital gains that will arise on redemption of mutual funds.

Suppose you invest 1 lakh in a debt fund in March 2013, with say an average portfolio maturity of five years. Now you will get accrued interest of approximately 9% on this investment. Since you have invested for more than one year, you are liable to pay long term capital gains tax. As per tax laws, you have the option of paying tax on long-term capital gains with or without indexation. Assuming a 9% return on your investment, your total fund value will be 1,09,000 (investment 1,00,000 and a capital gain of 9,000) in April 2014 . Now the tax calculation works as follows:

The CII (cost inflation index) for the year 2012-13 is 852. Assuming 7% inflation, for the next two years, the CII for 2013-14 will be 911 and that for 2014-15 will be 975.

If the debt fund is redeemed in April 2014, you can also take into account the CII of 2014-2015. So, your adjusted investment amount considering 2 years CII would be (975-852)/852*10,000 = 1,14,437.
Your maturity value, considering 9% accrued interest would be : 1,09,000/-
Long Term Capital Gains = 1,09,000 - 1,14,437 = (5,437)

Thus, as per the calculation, you make a loss of Rs. 5,437. That means you will pay zero tax, or your returns are tax- free.
In fact you can even carry forward this loss for eight years and can set it off against long-term capital gains.

Had you invested one month late or withdrew one month early (in nutshell, if you do not time your investment and maturity correctly), you would have actually made a gain of Rs. 1,000/- on which you would have paid 20% long term capital gains tax.

For risk averse investors looking to invest in the debt market, making an investment in March every year could be fruitful. These kind of tax free returns are anytime better than Fixed Deposits, which are least tax efficient.