We often consider it to be good news when prices increase at a slower rate. However, it may not be such a good thing if you have long-term capital gains from taxable investments. The continuous decline in inflation over the last 3 to 4 years is an indication of the fact that capital gains over the long term will no longer be viable for tax relief via indexation.
Inflation at the time of holding period is taken into account by indexation and then the purchase price of some assets is adjusted accordingly. Such upward revision decreases capital gains and lowers the overall taxation liability.
Consumer inflation was at all time highs of double digits in the period from 2008 to 2012. This meant that investors in debt funds were making tax free gains. It is important to note that inflation was so bad during this period that investors were able to book notional losses and correct them against other kinds of tax-payable long-term capital gains.
Any person who made an investment of INR 2 lakhs in some debt fund on April 1, 2011, would have made profits of INR 56,800 over the next 3 years. However, as CII or cost inflation index shot up by 9.3 percent during this period, the person would have booked INR 4,068 as notional loss on the debt fund investment. This loss in earnings could be adjusted against other types of long-term capital gains. Additionally, the investor could carry forward the losses that were not adjusted for up to 8 financial years.
Decrease in inflation, reduced benefits
Consistent decline in inflation has put an end to the party of the past decade. The CII figure as notified by the government is 272 for the ongoing 2017-18 financial year. According to this information, increase in inflation stands at 3 percent over the last 1 year. There has been a steady slowdown in the rise in cost inflation index since 2013-2014 when it had risen by 10 percent.
The steady decline in CII has resulted in consistent rise in incidences of taxation on capital gains. A person who had invested INR 2 lakhs in April 2012 would have reaped good earnings of about INR 60,000 over the next 3 years. However, inflation during this period was low at 6.3 percent and hence the investor had to pay a comparatively small sum of around INR 7,700 as tax after indexation.
Investors will need to pay even higher tax in the current year. The average returns on short-term bond funds as of April 1 were 8.9 percent over a period of 3 years. The inflation for this period was however 4.3 percent, which results in an effective tax of 10.4 percent on capital gains.
In the near future, inflation is expected to stay muted and hence increased tax on capital gains is likely to carry on. Investors became accustomed to zero incidences of tax on capital gains due to increased inflation some years ago. However, the tax burden on varied investments is now mostly like to rise. All the instruments with option of indexation tax relief will see a decline in the post-tax earnings.
Over the recent past few years, there have been changes to rules pertaining to capital gains. In 2014, the minimum holding period for debt or debt-linked mutual funds which were to be categorized as long-term assets was increased from 1 year to 3 years. As opposed to this, the minimum holding period associated with real estate was decreased to 2 years from 3 years. Hence, investors need to find the right time of the year to make investments in any kind of capital asset.
Maintain records of all transactions
Investors in mutual funds can easily calculate their tax liabilities. Almost all the fund houses permit users to download annual statements of their individual capital gains. The investor will however need to keep records of all other kinds of transactions such as purchase of property, gold, jewelry, etc.
Several investors in mutual funds do not opt for tax benefit claims associated with capital losses as it makes their tax return filings unnecessarily complicated and complex. As per taxation rules, it is not possible for people to revise their tax returns after the assessment is finished. Hence, investors who failed to list a capital loss that was booked some years ago may consider it to be forever gone.
The right thing to do for investors
Financial and investment experts are of the opinion that investment in such instruments is still beneficial as indexation helps reduce the overall tax liability. They maintain that it is better off to take the indexation gains available under the new tax regime for debt funds, than get no tax benefits. The incidence of taxation will be much higher if there was no indexation. It is best for investors who put their money in bond funds over the last 6 to 12 months to remain invested for the holding period of 3 years. Otherwise the gains will incur taxation at a rate which is equal to their income tax bracket.