How do I understand the taxation of capital gains on debt funds more practically?

Let’s say you invested in a debt fund in May 2013. Your investment amount was ?50,000 and you bought the units at an NAV of ?10 giving you 5000 units in total. Let us, for the purpose of simplicity ignore the effect of other costs. In May 2018, you redeemed your 5000 debt fund investments units in the debt fund at a NAV of ?16 realizing Rs.80,000 in the process. Before we get into the tabular calculation, let us spend a minute with the concept of Indexed Cost of Acquisition for greater clarity. One more thing to remember here! While in the past debt fund investors had the choice to pay tax at 10% on flat gains or 20% on indexed gains, that has been scrapped and now investors have to necessarily pay tax on indexed capital gains only at the rate of 20%. But will also show you a comparison of the two methods for your understanding.

In the above case, since your holding period is more than 3 years (5 years in this case), you will get the benefit of indexation to reduce the value of your long-term capital gains.

To arrive at the Indexed Cost of Acquisition (ICoA), you have to use the following formula:

ICoA = Original cost of acquisition * (CII of year of sale/CII of year of purchase)

Now let us tabulate the results of the above illustration in a table…

In the above illustration, the investor would be almost indifferent between indexing and paying 20% and not indexing and paying 10% flat tax. However, when inflation rates are much higher, the impact of indexation is felt higher and that is when the concept of indexation works more to your benefit. Normally, over longer periods of time it has been noted that the indexed approach works better than the flat tax approach.