"Debt" the word itself means loan. Debt mutual fund gives loans to government, businesses and financial institutions, and hence Debt funds invest into fixed income securities such as Treasury Bills, Government Securities, Corporate Bonds, Money Market instruments and other debt instruments of different time horizons.
Indexation means adjustment of gains with respect to Inflation i.e. subtracting the impact of inflation on your returns and then paying taxes. Inflation here is calculated based on CII (Cost Inflation Index) provided by Income tax department each year. Let us understand the calculations with an example.
Example: Suppose you invested ₹10 lakhs in 2010-2011 in a Debt Fund. Assume the fund returned 10 percent a year, and you redeem it for ₹16,10,510 after 5 years i.e. in 2015-16. Since you sold the fund after 36 months of holding period, your capital gains will be considered as Long term Capital gains. Capital gains in this example would be ₹6,10,510 (Redemption amount – Invested Amount).
Now CII (available on Income Tax Dept. website) for 2010-11 was 167 and 2015-16 was 254. So, we will adjust the value of our investments made in 2010-11 to the value of the same investments which stand as of 2015-16 i.e. year of redemption.
The calculation is done as follows:
(CII at redemption Year/CII at Investment Year) X Invested amount = Indexed Investment amount
254/167*10 Lakh = ₹15,20,958 (Indexed Investment Amount)
So, now the long-term capital gain would be
Redemption amount - Indexed Investment amount = ₹16,10,510 – ₹ 15,20,958 = ₹89,552
A 20% taxation on this amount would be ₹17,910. This is less than 3% of your gains (₹6,10,510). Hence, we will be paying taxes on the returns earned over and above the inflation adjusted initial investment.
As proposed in Budget 2020, companies will not be required to pay Dividend Distribution Tax (DDT). Dividend income from mutual funds is now taxable in the hands of the recepient at applicable income tax rates.