Understanding Inflation Indexation in calculation of Long Term Capital Gains Tax
Capital Gains Tax is paid out of the amount that qualifies as capital gains from the purchase of an asset.
Capital Gains = Purchase price – Selling price
The formula works if there is no inflation indexation benefit
In case there is an inflation indexation benefit provided by the government, the formula differs.
In present case, Indian government has fixed an inflation indexation benefit for long term capital gains tax to be 20 per cent for the fiscal year 2014-15.But what is the formula to calculate a capital gain on purchase of an asset.
The benefit of the same is that it helps in lowering the payable tax amount on long-term capital gains tax.
It is a technique through which cost price of an asset is adjusted with inflation. Using the technique purchase price of an asset is multiplied with the indexing factor.
Indexing factor = Inflation level of current year/ inflation level of the year when asset was purchased
For example, Ashish purchased a long term income fund in the year 2009 for Rs 100. The inflation index level was at 110. I then sell these units in 2014 for Rs 160. Inflation index level was at 125 during the year of sale.
Indexing factor = 125/110 = 1.14
Index Purchase Price = Indexing factor*Actual purchase price = Rs 114
Capital gain with indexation = Selling price – Indexed Purchase Price
Rs 160 – Rs 114 = Rs 46
I will be paying capital gain tax of 20 per cent on Rs 46 after adjusting for inflation i.e. Rs 9.2.
My net capital gain is Rs 50.8 on my investment of Rs 100 on long term income fund.
My five-year CAGR on this investment is 8.50 percent.