You may wonder as to why this rate of inflation is so important when it comes to investing. The fact is that inflation gets into asset values through a process called indexing or the cost inflation index which is used to inflation the present value of assets purchased in the previous years. Let us consider an illustration to understand this point better.

Saroja has invested Rs.10,000 in a debt mutual fund which gives her 8% returns each year on an average. Since it is a growth fund, there is no dividend paid out in between. Effectively at 8% annualized returns grows to become Rs.14,693 at the end of 5 years. Now Saroja has a tax challenge. Since she has held the debt fund for more than 3 years it will be considered as long term capital gain (LTCG). Now Saroja has a capital gain of Rs.4,693 (Rs.14,693 – Rs.10,000). So should she pay tax on Rs.4,693? The answer is no!

While Saroja has earned returns of 8% annualized, part of that returns were eaten away by inflation effect. You need to factor that in. For example if you consider the future value of Rs.10,000 with inflation of 5% then it is Rs.12,763. That means instead of Saroja’s effective taxable capital gains should not be Rs.4,693 but only Rs.1,930 (14,693 – 12,763). That actually looks fair to Saroja as she can now pay lower tax. For the purpose of payment of LTCG on her debt fund, the amount of Rs.1930 will be considered and not Rs.4693. That is exactly how the Income Tax Act also taxes capital gains net of inflation. It is just that the Income Tax Act approaches this issue is a slightly different way so as to standardize the entire process. Obviously, if you leave it to discretion to calculate the inflation rate then there is not standardization, so the IT Act creates the CII or the cost inflation index which is updated each year and announced. That is how indexation works.

NISHA Nayakanswered.You may wonder as to why this rate of inflation is so important when it comes to investing. The fact is that inflation gets into asset values through a process called indexing or the cost inflation index which is used to inflation the present value of assets purchased in the previous years. Let us consider an illustration to understand this point better.

Saroja has invested Rs.10,000 in a debt mutual fund which gives her 8% returns each year on an average. Since it is a growth fund, there is no dividend paid out in between. Effectively at 8% annualized returns grows to become Rs.14,693 at the end of 5 years. Now Saroja has a tax challenge. Since she has held the debt fund for more than 3 years it will be considered as long term capital gain (LTCG). Now Saroja has a capital gain of Rs.4,693 (Rs.14,693 – Rs.10,000). So should she pay tax on Rs.4,693? The answer is no!

While Saroja has earned returns of 8% annualized, part of that returns were eaten away by inflation effect. You need to factor that in. For example if you consider the future value of Rs.10,000 with inflation of 5% then it is Rs.12,763. That means instead of Saroja’s effective taxable capital gains should not be Rs.4,693 but only Rs.1,930 (14,693 – 12,763). That actually looks fair to Saroja as she can now pay lower tax. For the purpose of payment of LTCG on her debt fund, the amount of Rs.1930 will be considered and not Rs.4693. That is exactly how the Income Tax Act also taxes capital gains net of inflation. It is just that the Income Tax Act approaches this issue is a slightly different way so as to standardize the entire process. Obviously, if you leave it to discretion to calculate the inflation rate then there is not standardization, so the IT Act creates the CII or the cost inflation index which is updated each year and announced. That is how indexation works.