Cost Inflation Index

Everything around us keeps on changing, including the prices of everyday necessities. A kilogram of apples, which cost less than ₹50 a few years ago, is now over ₹200. As the prices of products increase, the purchasing power of money decreases due to inflation.

The Cost Inflation Index is a tool used in the calculation of an estimated yearly increase in asset prices as a result of inflation. It is essential to know about this tool to understand inflation’s impact on our livelihood and investments. In this article, we will learn what the Cost Inflation Index is, how it works, how it can be calculated, and how it is used in income tax.

The Cost Inflation Index (CII) is calculated to match the prices to the inflation rate. If we have to explain it simply, an increase in the inflation rate over time will lead to a rise in the prices. The Central Government of India takes care of and publishes the index in the official gazette.

Typically, for the calculation of CII, gains on long-term capital are taken into consideration. Capital gains mean the profits you gain when you sell capital assets like property, plots, agricultural land, bonds, stocks, etc.

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

Due to inflation, capital asset prices are likely to rise from the time of purchase to the time of sale. Hence, the selling of assets will most likely increase the net worth of the owner as the sale price is higher than the purchase price. We already know that the government levies tax on the sale or purchase of a property. So, you would be asked to pay more tax than required because of inflation.

Here's where the Cost Inflation Index comes into the picture as CII adjusts the purchase price according to the sale price, which has increased due to inflation. The Cost Inflation Index is fixed every year by the Indian Government before the end of the financial year.

CII is used to calculate Long-Term Capital Gains (LTCG) of investments and assets, which include real estate, gold jewelry, debt mutual funds, and so on. With the value of CII, you can know the real gain on the sale of an asset. The CII is used to analyze an asset's inflation-adjusted cost price. Long-term capital gains or losses are then calculated using the inflation-adjusted price. On the other hand, the CII cannot be utilized for gains on equity shares and equity mutual funds that are taxed at a rate of 10% without any indexation benefit.

When you sell a capital asset or property, you have to pay capital gains tax. This tax is levied on the difference between the sale price and the purchase price. We all know that the value of a property increases over time. Hence, its sale is also done at a higher price. This increases the difference between the sale price and the purchase price.

When the value of a property increases over time, so does the value of money, thanks to inflation. This means you have to pay higher income tax on the gains from these assets.

So, what's the connection between the value of a property and CII? Because CII artificially inflates the cost price of your property or asset. This reduces the difference between the sale price and the cost price. It also reduces capital gains tax. Hence, this leads to lower profits and lower tax amounts on the property.

Long-term capital assets are recorded at cost price in books. In spite of increasing inflation, these assets exist at the cost price and cannot be revalued. When you sell these assets, the profit amount remains high because of the higher sale price as compared to the purchase price. This leads to a higher income tax that you need to pay when you sell the asset.

The Cost Inflation Index is applied to the long-term capital assets, because of which purchase cost increases. This means, there will be lower profits and lower taxes to benefit taxpayers. In order to benefit the taxpayers, the Cost Inflation Index is applied to long-term capital assets.

Before we learn how to calculate the cost inflation index, you need to know the cost inflation index for the below financial years.

We have learned about the Cost Inflation Index table. To properly understand how the calculation of the Cost Inflation Index work, we need to understand the meaning of base year in CII.

The base year is the first year of the Cost Inflation Index and has an index value of 100. The index of all other years is compared to the base year to see the rise in inflation percentage. For any capital asset purchased before the base year of the cost inflation index, taxpayers can take the purchase price as higher than the actual cost or Fair Market Value (FMV) on the first day of the base year.

The benefit of indexation is then applied to the purchase price of assets. Meanwhile, FMV is calculated based on the asset's valuation report as presented by a registered valuer.

How To Calculate The Cost Inflation Index?

Here's the formula to calculate the cost inflation index:

Let's take an example to understand four-year indexation. Ramesh invests ₹1 lakh on 1st Mar 2017 and redeem money on 3rd April 2020 for ₹1,25,000. Your investment covers 5 financial years and investment in more than 3 years, so you can have four-year indexation.

Your cost of acquisition will be ₹1,14,015.15 (1,00,000*301/264) and taxable income will be ₹10,984.85 (1,25,000 -1,14,015.15) for computation of capital gain taxes. If you had withdrawn your investment before 31st of March 2020 but after 1st Mar 2020, your cost of acquisition would have been ₹1,09,469.70 (1,00,000 *289/264) and taxable income will be ₹15,330.30 (1,25,000-1,09,469.70).

If you plan your purchase and redemption properly, you can save additional capital gain tax, just like how you were able to save ₹4345.45 at applicable rates.

As we have mentioned before, CII is used to calculate the inflation-adjusted asset acquisition cost for the computation of LTCG assets. This indexation can help reduce tax liabilities. The amount of tax applicable on long-term capital gains obtained from the transfer of assets like mutual funds and real estate can be reduced by the taxpayer.

So, how can you do it? It can be done by tweaking their total invested amount per the asset purchase CII. For example, any gain obtained by you from the transfer or sale of an asset will attract relevant capital gains taxes, whether you held them for a short-term or long-term.

If you hold the asset for less than 24 months, the gains on the transfer of those assets will be treated as short-term capital gains and will not be indexed. On the other hand, if you hold the asset for more than 24 months at the time of the sale or transfer, the CII application will be taxed at a 20% tax rate.

But how does this help you? The gain amount is automatically reduced when CII is applied to the wealth gain. Hence, the amount taxed is also reduced, lowering your tax liability to LTCG.

The reduction in tax obligation is one of the main reasons for the jump in subscriptions and issuance of pension funds and fixed-term pensions (FMPs). Hence, implementing CII in LTCG allows beneficiaries to leave a surplus after paying taxes on long-term profits. This surplus can be further used to invest in other financial instruments.

There are a couple of points you need to understand before you leave this article.

The Cost Inflation Index (CII) is a tool that helps taxpayers to reduce their tax liability. It is important to know everything about the index so that you can calculate the tax on your long-term capital gains correctly. We hope this article helped you understand the concept clearly. If you have any questions about this, please reach out to us.

If you wish to learn more about other topics such as Capital Gains Tax, Inflation, Equity Mutual Funds, Debt Mutual Funds, Hybrid Mutual Funds, ELSS funds, and other types of investment instruments, such as Fixed Deposits, Digital Gold, Smart Deposits, head over to our Blogs section. You can also check out our Calculators, where you can learn more about how much wealth you can accrue in certain years.

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