The world’s economy is dynamic and subject to constant change. This change is evident from a decrease in the purchasing power of money due to a sustained rise in the prices of goods and services. The phenomenon of a reduction in the value of money, which leads to an increase in an individual’s cost of living, is known as inflation.
Cost Inflation Index or CII is a tool used in the calculation of an estimated yearly increase in an asset’s price as a result of inflation. The Central Government fixes this index and publishes it in its official gazette for measuring inflation. This index, notified each year by the Government is defined under Section 48 of the Income Tax Act, 1961.
What is the Purpose of CII?
A Cost Inflation Index table is used to calculate the long term capital gains from a transfer or sale of capital assets. Capital gain refers to the profit acquired from the sale/transfer of any capital assets, including land, property, stocks, shares, trademarks, patents, etc.
In accounting, usually, long term capital assets are recorded at their cost price in books. Thus, despite rising prices of assets, these capital assets cannot be revalued.
Thus, at the time of sale of these assets, the profit or gain acquired from them remains high due to their high sale price in comparison to their purchase price. As a result, assessees also have to pay a higher income tax on the gains from these assets.
With the application of Cost Inflation Index for capital gain, in the long run, the purchase price of assets is adjusted according to their sale price, leading to lower profits and lower tax amount on them.
The Central Board of Direct Taxes in February 2018 notified new Cost Inflation Index numbers applicable from 2017-18 onwards. In this revision, there was a shift from the old base year of 1981 to 2001, with 100 taken as its CII. The indices for subsequent years were also revised accordingly.
This revision in the base year was prompted to solve the difficulties faced by taxpayers in the calculation of tax payable for gains from capital assets purchased on or before 1981.
Following are two tables illustrating new and old Cost Inflation Index for the last ten financial years –
Old CII Table –
New CII Table –
The new CII is crucial for assessees to calculate their long term capital gains in accordance with the inflation for the financial year 2017-2018 and assessment year 2018-19.
What Does a Base Year in CII Mean?
The base year is the first year in the index whose value is set at 100. The indexation of years following base year is done in accordance with base year to check their increase in the inflation percentage.
For assets purchased before the base year of CII, assessees can consider their purchase price as the higher between their Fair Market Value and the actual cost of the same on 1st day of the base year. The benefit of indexation is then applied to the calculated purchase price of assets. On the other hand, FMV is calculated based on the asset’s valuation report as presented by a registered valuer.
How is Indexation Applied for Long-Term Capital Assets?
Indexation is applied to cost of asset acquisition to adjust the price of assets in accordance with inflation. Following is the formula to calculate indexed cost of asset acquisition –
Indexed cost of asset acquisition =
CII for the year of sale or transfer x Cost of asset acquisition)/ CII for the first year in the holding period of asset or year 2001-02, whichever comes later
Following is the formula to calculate the indexed cost of asset improvement –
Indexed cost of asset improvement =
CII for year of sale or transfer x Cost of asset improvement)/ CII for year during which the asset improvement took place
Example of Application of Indexation for Long-Term Capital Assets –
Mr Paul invested in the purchase of a capital asset in Financial Year 1994-95 for Rs. 1,00,000. Fair Market Value of this capital asset on April 1st 2000 was Rs. 2,20,000. He then proceeded to sell this asset in the financial year 2015-16.
Following is a calculation of the indexed cost of asset acquisition –
In the case mentioned above, the asset is purchased before the base year. Therefore, cost of asset acquisition, in this case, = Higher between FMV and actual cost of the asset, as on April 1st 2000.
Therefore, cost of acquisition of this asset = Rs. 2,20,000.
CII for the year 2001-02 and 2015-16 is 100 and 254 respectively.
Therefore, indexed cost of asset acquisition = (2,20,000 x 254)/100 = Rs. 5,58,800
Things to Note about Cost Inflation Index India –
While calculating the indexed cost of asset acquisition of an assessee, there are a few critical points assessees should bear in mind. These are –
- If an asset is received at an assessee’s will, CII is considered for the year in which it is received. In this case, the asset’s actual purchase year is to be ignored.
- Any improvement cost incurred before April 1st 2001 is not viable for indexation.
- Benefits of indexation are not applicable for debentures or bonds, apart from RBI issued sovereign gold bonds or capital indexation bonds.
How Can Indexation Reduce Tax Liabilities on LTCG for Assesses?
The CBDT has set the Cost Inflation Index for FY 2019-20 at 289, adjusting it from 280, which was the CII for FY 2018-19. Since CII is utilised to calculate the inflation-adjusted cost of asset acquisition for computation of LTCG of assets, this indexation can help to reduce tax liabilities on the same.
Assessees can bring down their quantum of tax applicable on long term capital gains acquired from the transfer of assets like debt mutual funds, real estate, etc. by adjusting their total invested amount in accordance of the CII of asset purchase and sale years.
For example, any gain acquired by an assessee from transfer or sale of a property will attract relevant capital gain taxes, whether long or short term. If the holding period of said property is less than 24 months, then the gains arising from a transfer of these assets are considered short term capital gain and is not applicable for indexation.
However, if assessees have held an asset for more than 24 months during the time of sale or transfer, then they are taxed at a rate of 20% with CII application.
When CII is applied to gains from property, the quantum of profit is automatically reduced. Thus, the amount on which taxes will be levied will also be reduced, thus bringing down an assessee’s tax liabilities on LTCG.
This reduction in tax liability is one of the primary reasons for an increase in the subscriptions and issuance of bond funds and Fixed Maturity Plans (FMP). The implementation of CII on LTCG, thus, can leave assessees with a surplus after their tax payments on long-term gains, which they can further utilise to invest in other financial instruments.