The True Cost of Indexation

The concept of indexation is to adjust for the inflation that has eroded purchasing power between the date of acquisition of an asset and its subsequent sale. Inflation reduces purchasing power over time and acts as a silent tax on all citizens of a country. Without the inflation adjustment through indexation, assets held for years may end up paying an exorbitantly high tax. 
This was the reason why indexation was introduced via the second proviso to Section 48 basis the Chelliah Committee report. The report argued that a hedge against inflation was essential for such assets.

How Indexation works
Indexation accounts for the inflation between the date of acquisition and sale of a long-term asset by increasing the cost of acquisition to its current purchasing power. CBDT releases a Cost Inflation Index (CII), which is 75% of the Consumer Price Index (urban) as released by the Government of India. 
The formula for indexation is:
Indexed cost = CII of the year of sale x Cost of acquisition
          
CII of the year of acquisition
For an asset bought in 2001 (year of acquisition), the CII is 100
For an asset sold in 2024 (year of sale), the CII is 363
Thus the indexed cost is 3.63 (363/100) the original cost of acquisition. This shows that a rupee in 2001 has the same purchasing power as Rs 3.63 in 2024. This only applies to Long Term Capital Gains (LTCG), ie, capital assets held for more than 2 years. Capital assets include gold, securities, property, land, building, etc.

Analysis of the Removal of Indexation 
The removal of indexation by the Finance Minister (FM) also saw a 37.50% reduction in the LTCG rate from 20% to 12.50%. The average inflation as per CPI is 4.99% from April 1, 2014 to April 1, 2024. To analyse the impact, a comparison of the return on investment across holding periods is merited under both regimes: 
⦁    the older LTCG regime (20% tax with indexation)
⦁    the new LTCG regime (10% tax with indexation)

Calculations courtesy Nandish BS, Data Sciences Team, 3one4 Capital

The chart shows the ROI (return on investment) against the Holding period of the asset. The cells reflect the Rate of Return (CAGR) of the assets being sold. The colours indicate the scheme which is more beneficial for the tax payer. Yellow indicates that the older indexation regime is more beneficial while green indicates that the new, lower tax rate regime is more beneficial.
Thus capital assets which yielded a rate of return above 11per cent on average over a 10 year period will benefit from the new LTCG regime as opposed to the older one.

Performance of various Long Term Asset Classes over 10 years
An analysis of three asset classes across a 10 year period in terms of their rates of return is given below:

⦁    House Property data from the RBI’s All-India House Price Index (HPI) 
⦁    Gold prices from in.investing.com
⦁    Unlisted equities prices from the performance of CAT I AIFs as per the SEBI mandated benchmarking report published by CRISIL
From the data, both investors in House Property and Gold would suffer on average under the new LTCG regime as opposed to the older one. The uproar on house property was especially strong, given that many taxpayers have the majority of their wealth in house property investments. The Indian government also incentivised house property as an investment avenue through various tax breaks such as:
⦁    Reinvestment of capital gains in house property being tax exempt up to Rs 10Cr (section 54 and 54F)
⦁    House property principal being a tax deduction under Section 80C
⦁    Interest on house property being a deduction
⦁    30% automatic reduction on rental income

Market Feedback post the Budget
Several organisations and taxpayers made representations to the FM to grandfather the indexed costs up to April 1, 2024. This is similar to how the FM grandfathered the market price up to January 31, 2018 when the 10 per cent tax on listed equities was introduced on February 1, 2018. The late Shri Arun Jaitley promised to stop retrospective amendments and this new LTCG regime is retrospective in nature. Grandfathering refers to preserving elements of an older regime in the new regime.

Amendments proposed by Finance Minister
The FM has taken market feedback and announced that for land and building purchases before July 23, 2024, the taxpayer can pay tax at the lower of the old LTCG regime and the new LTCG regime. Though this isn’t indexation or grandfathering, it has a similar effect.
Investors in gold and unlisted securities saw no benefits.

Inflation ravages savings of all investors, regardless of whether they invest in gold, land or securities. The government’s move offers relief to real estate sector, but not others. But this move will benefit the largest number of taxpayers in absolute numbers.

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