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Indexation only comes into picture when you incur capital gains, and that's because indexation helps to take into account the effect that inflation has on an asset purchase.
If you buy a house in 1985 and sell it today, there will be a huge difference in price, and it's not fair to tax you the whole difference because a large part of the difference is simply due to inflation.
Indexation makes sure that inflation is taken into account while calculating capital gains, and you are only taxed on that part of your capital gains which are over and above the price rise caused by inflation.
The table that is used for this is called the Cost Inflation Index and that's calculated by the RBI based on the inflation numbers.
Here is a link that shows you the Cost Inflation Index (CII) numbers from 1981 – 82 to 2011 – 12. The CII for the financial year 2010 – 11 is 632 and for 2011 – 12 is 711.
The CII is used to calculate what's called the indexed cost of acquisition and this number bumps up the original price to match inflation.
The way you calculate the indexed cost of acquisition is by using the following formula:
Original purchase price x (Index value in the current year / Index value in the original year)
In the case of FMPs, the original purchase price is nothing but the money you invested.
Let's say you bought a FMP of a maturity of 370 days with Rs. 1 lakh in FY 2010 – 11 and sold it in FY 2011 – 12. To calculate the indexed cost of acquisition you will input the numbers in the above formula and get the new indexed value.
1,00,000 x (711 / 632) = 1,12,500
Let's say after 370 days – the FMP rose to Rs. 1,12,500 which means it gained 12.5% in just over a year. To calculate the capital gains – you will need to subtract the indexed cost of acquisition with the selling price.
In this example both are the same so you won't end up paying any tax.
There are a couple of things to keep in mind about this – indexation only works for long term capital gains which accrue after you have held the FMP for a year, so that's why you see a lot of FMPs that have a maturity period of slightly over 365 days.
Secondly, what Direct Tax Code eliminates is the double indexation benefit of FMPs which meant that you could buy something in March 2010 and sell it in April 2012 and make it span across two financial years. The DTC won't allow this, but as far as I know FMPs will still be tax efficient when compared with fixed deposits because of the way indexation works.
Hemant has already done this comparison so you can see how the FMP returns compare with fixed deposit returns there.
Finally, Vijay brought up the point that if the maturity of the FMP is less than a year then it's better to opt for the dividend plan, and if it's greater than a year then it's better to go for the growth plan and that's because dividend distribution tax is lower than short term capital gains which become applicable if you own the FMP for less than a year.
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