How you will get indexation benefit through Medium duration fund investments?

Debt fund schemes in India offer a wide range of investment options to investors, especially ones with a low-risk appetite or who want to avoid market volatility. With SEBI’s categorization and rationalization exercise in 2017, there are currently 16 debt fund schemes in India. Investors have ample choice available and can opt for a scheme which is in line with their investment objectives. 

This article will give you an overview of medium duration funds. 

Meaning of Medium Duration Funds

Medium duration funds are open-ended debt schemes that invest in instruments (debt and money market) such that the Macaulay duration ranges between three years and four years.

Medium duration fund investments have a longer maturity period than six debt variants (overnight, liquid, ultra-short, low duration, money market, and short duration funds). However, their maturity tenure is lower when compared to medium to long duration and long duration funds. This debt scheme is more likely to have higher interest rates, especially when compared to the shorter duration debt funds. Medium duration fund investments are ideal for investors who have a medium investment tenure (at least three years), low-risk preference, and are content with moderate returns. 

Indexation benefit for medium duration funds

For the purpose of taxation, medium duration fund investments (being debt schemes) qualify for indexation benefits. This benefit is applicable for long-term capital gains or when the investments are redeemed after a minimum period of three years. Indexation allows adjustments in the initial purchase price of your investment to account for inflation. The purchase price is inflated basis the inflation index of the year of purchase. As a result, your net gains go down and so does the tax payable.

Here is an example of how indexation helps to bring down your tax liability.

In August 2015, you put in Rs. 10,000 towards medium duration fund investments. You were allotted 1000 units at the NAV of Rs. 10. In the year 2019 (July) when the NAV had reached Rs. 20 you decided to redeem the investment. The value of your investment at that time was Rs. 20,000 (1000 units * 20 NAV per unit). 

Hence, your capital gains from this transaction were Rs. 10,000 (i.e. Rs. 20,000 – Rs. 10,000). However, as your investment holding period was more than three years you will and get the benefit of indexation. As a result, you will not need to pay tax on the amount of the entire gain of Rs. 10,000

In order to determine the taxable income, the Indexed Cost of Acquisition will be computed as:

Original investment or acquisition cost multiplied by (CII** of the redemption year divided by CII** of the acquisition year)

= 10,000 *(289/254) =Rs. 11,378

(**CII stands for the Cost Inflation Index. This value is determined by the Central Government. CII for the FY 2015-2016: 254. CII for the FY 2019-20: 289) 

Your net gains (for the purpose of taxation) from the sale transaction would now be Rs. 8622. The tax payable would be Rs. 1724 (20% Tax rate) as compared to Rs. 2000 without indexation.

Final Words

Indexation is the USP of debt fund schemes in India. It gives them an edge over conventional investment options such as FDs, etc. Medium duration fund investments, due to their longer maturity period amps up the potential for generating higher returns for investors. This coupled with indexation benefits makes medium duration fund investments a total win-win deal! But remember that indexation benefit kicks in only once you complete three years. Longer you remain invested, lower is likely to be your long-term capital gains tax.