The Concerns Around Budgetary Changes Made to Indexation and the LTCG Structure

Starting 1 April 2023, debt funds no longer received indexation benefits and were deemed to be STCGs.

Over the last few weeks, one of the more debated proposals of the Union Budget for 2024-25 has been the overhaul of the long-term capital gains (LTCG) tax regime. Finance Minister Nirmala Sitharaman had announced that the new regime will eliminate the indexation benefit for calculating the LTCG on assets such as property, gold, and unlisted investments while reducing the LTCG tax rate from 20 percent to 12.5 percent.  

While the proposal is likely to cause significant harm to investors and those from middle (and upper middle) classes, impacting key sectors such as real estate and mutual funds, it’s imperative to understand the concept and practice of indexation and how it affects LTCG taxation. 

Indexation as an accounting process adjusts the original purchase price of an asset to account for inflation, thereby neutralising the impact of inflation on capital gains. This adjustment helps in calculating a more accurate cost of acquisition by increasing the asset’s purchase price based on inflation over the holding period.

Under the new regime, the absence of indexation is likely to lead to higher tax liabilities for people, particularly for assets held over long periods. However, the government argues that this “simplification” will “streamline the capital gains tax structure”, eliminating the differential tax rates for different asset classes and potentially easing compliance for both taxpayers and tax authorities. It might not be so. 

Several industry analysts and stakeholders have now raised concerns about the prospective implications of the proposed changes. One notable worry is that the removal of indexation may drive an increase in secondary market real estate sales. This is because investors may prefer to sell their assets within three to five years rather than holding them longer.  

As for those holding property over extended periods with annual capital value growth of around 10-12 percent, the new tax regime could result in higher tax liabilities. Conversely, shorter holding periods of three to five years might make it easier to sell, as the tax impact would be less severe in the short term, potentially making it more attractive from a capital appreciation standpoint. 

Another concern is that the new tax regime could encourage cash transactions in property deals. Sellers might be tempted to underreport the actual transaction value to reduce their tax liability. According to the Reserve Bank of India’s latest Housing Price Index, property values have increased by only about 4.5 percent to five percent over the past decade barely keeping pace with inflation, As a result, the new tax regime could disproportionately impact property owners, leading to significantly higher tax bills due to the loss of indexation benefits. 

Similarly in the top seven metropolitan areas, Anarock Research reports that property prices per square foot rose just one percent between 2018 and 2019 and remained stagnant between 2019 and 2020. Although there was a modest two percent increase in 2021 and a five percent rise in 2022, the trend improved in 2023 with an 11 percent increase. Similarly, Colliers India estimates that price increases have averaged around nine percent over the past three years in major metros, causing this to negatively affect the middle class.  

Similarly, the prescribed changes in tax also affect investments in gold and debt mutual funds. Despite occasional spikes, gold prices have historically increased by about 9.92 percent over the last decade, below the 11 percent threshold needed to benefit under the new tax regime.

Debt mutual fund investors face substantial tax increases. Previously taxed at 20 percent with indexation, they will now be taxed at 12 percent without indexation. Investors holding funds for less than a year will see their tax rate increase from 15 percent to 20 percent. 

Debt funds are those mutual funds whose portfolio’s debt exposure is more than 65 percent and equity exposure is not more than 35 percent. Starting 1 April 2023, the debt funds had no longer received indexation benefits and were deemed to be short-term capital gains (STCGs). Therefore, any gains from debt funds were added to your taxable income and taxed at the slab rate. This included investments via SIP (Systematic Investment Plans) and other schemes. 

With the current change, profits gained from investment in mutual funds are known as ‘Capital Gains’. These capital gains are subject to tax and debt mutual fund investors face substantial tax increases. It is to be noted that this is applicable only if the debt mutual funds are purchased after 31 March 2023. The following table will help you understand better (sourced from here). 

No indexation benefit will be available while calculating long-term capital gains on Debt Mutual Funds (ie, mutual funds that invest less than 35 percent of their corpus in equities or equity-related instruments). Debt mutual funds will now be taxed as per the investor's applicable slab rates. This is only applicable for debt funds investments done after 1 April 2023 (for details on what factors determine the tax on mutual funds see here). 

Previously taxed at 20 percent with indexation, they will now be taxed at 12 percent without indexation (one needs to carefully see which scheme and investment plan would have what tax implications-as shared in the table above). Investors holding funds for less than a year will see their tax rate increase from 15 percent to 20 percent. 

The longer one holds on to their mutual fund units, the more tax-efficient they become. The tax on long-term capital gains will also be comparatively lower than the tax on short-term gains. 

Long-term investors in debt mutual funds previously benefited from indexation, which, after holding the investment for five or six years, significantly reduced their tax liability on the modest returns of six to seven percent typically offered by these funds.  

The finance minister assured in the last Budget that existing holdings would be grandfathered, offering some protection to these conservative investors. However, it appears that with the new tax regime, the promise will not be withheld. Investors argue that indexation was removed for all unlisted physical and financial assets without any warning or grace period, leaving them in the same tax bracket as investors in higher-return assets like property and gold.  

During the Rajya Sabha discussion on the Union Budget 2024-25, AAP Member of Parliament Raghav Chadha called for the central government to reconsider its decision, arguing that the changes could make it nearly impossible for people to afford their “dream homes.” He warned that the new tax regime might lead to increased corruption in the real estate sector and could dampen investment in the industry. 

Chadha said, “Restoring indexation on long-term capital gains is essential. Globally, investors are encouraged through tax incentives. In contrast, by removing indexation, we are disincentivizing investment in India. This move doesn’t just impose a tax but essentially penalises investors.” This is an accurate interpretation of the proposed changes.

In response to the backlash, Union Finance Minister Nirmala Sitharaman on Wednesday formally amended the budget proposal to remove indexation for computing long-term capital gains (LTCG) tax by giving an option to individual taxpayers to choose between the old regime of 20 percent levy with indexation and the new system of 12.5 percent tax without indexation.

Overall, the Modi government may ultimately need to reconsider its approach to simplifying the tax regime through such ad-hoc, consequentially insensitive actions. Implementing a phased transition may always help mitigate the immediate financial impact on those who have made long-term investments based on previous tax rules. By gradually introducing minor changes and providing adequate time for adjustment, the government can also alleviate potential burdens on investors and ensure a smoother adaptation to the new tax structure. 

(Deepanshu Mohan is Professor of Economics, Dean, IDEAS, Office of Inter Disciplinary Studies, and Director, Centre for New Economics Studies (CNES), OP Jindal Global University. He is a Visiting Professor at the London School of Economics, and a 2024 Fall Academic Visitor to the Faculty of Asian and Middle Eastern Studies, University of Oxford. Aditi Desai is a Senior Research Analyst with CNES and a Team Lead of its Infosphere Team, This is an opinion piece and the views expressed above are the author’s own. The Quint neither endorses, nor is responsible for them.)