Cost Inflation Index

What is the Cost Inflation Index?

The Cost Inflation Index (CII) is a tool used to calculate long-term capital gains from the sale or transfer of capital assets like property, stocks, trademarks, and patents. Since these assets are recorded at their cost price in books, their value doesn't increase with market prices over time. When these assets are sold, the profit appears high due to their increased sale price compared to their acquisition price, leading to higher tax payments. However, applying the CII adjusts the asset's purchase price based on inflation, resulting in smaller gains and lower tax amounts in the long run.

Cost Inflation Index Formula = 75% average increase in CPI (Consumer Price Index) for the immediate previous year

Cost Inflation Index Table from FY 2001-02 to FY 2023-24

Cost Inflation Index in Income Tax

• Long-term capital assets are recorded at their original cost in books, not reflecting inflation over time.

• Upon sale, the higher selling price compared to the purchase price can inflate apparent profits, leading to higher income tax liabilities.

• The Cost Inflation Index (CII) is applied to long-term capital assets to adjust their purchase cost for inflation.

• This adjustment reduces taxable profits, resulting in lower income tax liabilities for taxpayers.

• The CII benefits taxpayers by aligning long-term asset purchase costs with inflation, easing their tax burden.

Concept of the Base Year in Cost Inflation Index

The base year in the Cost Inflation Index (CII) marks the starting point with an index value of 100. Subsequent years' indices are compared to this base year to compare inflation percentage. Assets acquired prior to this base year benefit from indexation applied to either the actual cost or Fair Market Value (FMV) as of the base year's first day, determined through a registered valuer's report.

Reason Why Cost Inflation Index is Calculated

The Cost Inflation Index (CII) is calculated to adjust for the effects of inflation on prices over time. As inflation rates increase, so do prices. The CII helps maintain a fair comparison of prices by factoring in this inflation. This index is important for various financial and tax-related calculations, ensuring accuracy and fairness in economic assessments.

Why Did the Base Year of Cost Inflation Index Change in 2001 from 1981?

The change in the base year of the Cost Inflation Index (CII) from 1981 to 2001 in 2001 aimed to alleviate challenges faced by taxpayers and tax authorities. Before this change, valuing properties bought before April 1, 1981, was cumbersome. Taxpayers and authorities struggled with accurate valuation, prompting the shift to 2001. This change allowed for quicker and more reliable valuations, enabling taxpayers to benefit from indexation by considering either the actual cost or the Fair Market Value (FMV) as of April 1, 2001, for assets bought before that date.

For Indexation of Long-Term Capital Assets

To calculate the indexed cost of asset acquisition,

Indexed Cost of Asset Acquisition = (CII at the time asset was sold X Cost of Acquisition) / CII at the time asset is possessed

To calculate the indexed cost of asset improvement,

Indexed Cost of Asset Improvement = CII at the time the asset was sold X Cost of Asset Improvement) / CCI at the time improvement is made

Points to Consider

• Property Inheritance: For properties received through a will, the Cost Inflation Index (CII) is determined based on the year of receipt, not the original purchase year.

• Exclusion of Pre-2001 Improvements: Improvement costs incurred before 1st April 2001 are disregarded when calculating CII for property.

• No Index Benefit for Bonds: Bonds or debentures, except for certain types like capital indexation bonds or sovereign gold bonds issued by the RBI, do not qualify for indexation benefits.

• Change in Debt Fund Indexation: As of 1st April 2023, debt funds no longer enjoy indexation benefits, affecting their tax calculations.

Practical Examples

Scenario 1: Property Sale (Indexed Cost of Acquisition):

Rohit bought a flat in 2001-02 for Rs. 10,00,000 and sold it in 2017-18. The CII for these years were 100 and 272, respectively. Using CII, the indexed cost of acquisition was calculated as Rs. 27,20,000. This indexed cost helps in determining the capital gains tax liability more accurately by adjusting for inflation.

Scenario 2: Capital Asset Sale (Pre-Base Year Purchase):

Rhythm purchased a capital asset before the base year (FY 1995-96) for Rs. 2,00,000, and its fair market value (FMV) in 2001-02 was Rs. 3,20,000. When she sold it in 2016-17, the indexed cost of acquisition was determined by using the CII for these years (100 and 264). The indexed cost was calculated as Rs. 8,44,800, providing a fair valuation for taxation purposes.

Scenario 3: Equity Shares Sale (Indexed Cost Calculation):

Kaneeka bought equity shares worth Rs. 1,00,000 in FY 2014-15 and sold them in FY 2020-21. With the CII of 240 and 301 for these years, the indexed cost of acquisition was computed as Rs. 1,25,416. This adjusted cost helps in accurately calculating the capital gains tax on the sale of equity shares.

Scenario 4: Sovereign Gold Bonds Redemption (Indexed Cost Calculation):

Akshat invested in Sovereign Gold Bonds (SGB) in FY 2015-16 for Rs. 2,00,000 and redeemed them prematurely in FY 2020-21 at the market price of Rs. 2,55,000. Using the CII of 254 and 301 for these years, the indexed cost of acquisition was determined as Rs. 2,37,007. This indexed value aids in computing the capital gains or losses accurately when redeeming bonds prematurely.

Conclusion

The Cost Inflation Index (CII) serves as a valuable tool for taxpayers in India. By accounting for inflation's impact on asset prices, the CII ensures fairer taxation on capital gains. This can result in significant tax savings, particularly when dealing with long-term investments. If you're planning to sell a capital asset in India, understanding and using the CII can be beneficial for optimizing your tax liability.