Inflation in India has risen significantly since the outbreak of the Covid pandemic as supply of various products and services has been impacted. Even prices of fuels like petrol, diesel and LPG have gone up significantly amid the rise in international crude prices and taxes. High inflation has created a hole in the pockets of consumers but it is certainly not bad for taxpayers as it reduces their tax liability.

Long-term capital gains, which enjoy indexation benefit, come down due to high inflation. It may be noted that indexation takes into account inflation during the investment period and adjusts the purchase price of the asset upward to reflect the impact of inflation. As a result your net capital gains come down and you pay lower capital gains tax.

How indexation benefit is applied in capital gains

The government announces a cost inflation index (CII) every year. This inflation rate is applicable for all the assets bought in the same financial year irrespective of the month of the year in which you bought the asset. For instance, an asset bought in the month of March FY18 and May FY18 will enjoy the same indexation benefit if they are sold anytime during the current financial year.

Index cost of an asset is calculated as follows:

Indexed cost of an asset= (Purchase Price*CII of year of sale)/CII of the year of purchase

Once you find out the indexed cost of an asset, 20% long-term capital gains tax is imposed on the difference of selling price and indexed cost of that asset. So more is the inflation more will be the indexed cost of the asset hence less will be tax on capital gains.

For the financial year 2020-21, CII increased by around 6% due to high inflation. But for FY20 and FY19, CII increased by around 4%.

However, all investments are not eligible for indexation benefit. Investment such as shares, fixed deposits and bonds and debentures that mention an interest rate are not eligible for indexation benefit. This is the reason why prudent investors go for debt mutual funds instead of fixed deposits, where interest income is taxable as per your tax slab.

In case of shares and equity mutual funds, long-term capital gains of more than Rs 1 lakh in a financial year are taxed at a reduced rate of 10% so no indexation benefit is given on that.