What is the Cost Inflation Index?

With the economy growing dynamically, the cost of commodities and services have increased over time reducing purchasing power. The goods that could once be bought at a lower rate cost twice as much today. This concept of reduction in money’s value that leads to a rise in the cost of living is termed inflation. The cost inflation index (CII) is an instrument that helps calculate the rise in the cost of commodities and services over each year due to inflation. 

The cost inflation index is a tool that is used to calculate the long term capital earnings resulting from the selling of capital goods and assets. Calculating inflation helps deduct the tax that you would have to pay on long-term capital earnings. The calculation of CII is done with the base/foundation year in mind. The base year is the first year on the index whose value is fixed at 100. The indexation of the years following the foundation year is then done accordingly to find the rise in the percentage of inflation. 

 

The CII is decided by the central government which is then published in the official gazette to help measure inflation. The index is specified under Section 48 of the Income Tax Act, 1961 and notified by the government every year. 

The cost inflation index assists in calculating the long term capital earnings from transferring or selling capital assets. The profit that is derived from the sale/transfer of capital assets such as stocks, agricultural land, shares, patents, property, trademarks etc, is known as capital gains. Usually, while accounting, long term capital assets are filed by their cost price. Therefore, despite the cost of assets constantly on the rise, capital assets cannot be appraised. 

 

As a result of inflation, the selling price of an asset is much higher than the initial purchasing price. Hence the net worth of the asset owner is also likely to increase. The cost of capital assets is higher at the time of sale than it is at the time of purchase. And since the government levies taxes when assets are sold or purchased, the owner of the asset would be forced to pay a higher tax than necessary due to inflation. 

 

This is where the cost inflation index comes into play. This index alters the purchasing price as per the selling price that has increased as a result of inflation. This leads to lower profits and, therefore, lower tax amounts. In 2018, the Central Board of Direct Taxes notified a new CII to be applicable from 2017-2018. During this revision, the base year was shifted from 1981 to 2001, and 100 was decided as the CII. This was an attempt to resolve the struggles faced while calculating the tax to be paid for gains derived from capital assets that were purchased on or prior to 1981.

Here’s how you can calculate the CII: 

 

Cost Inflation Index = CII for the financial year the capital asset was sold or transferred / CII for the financial year the capital asset was bought or acquired 

 

Given below is an example to help you understand how the calculation of CII works: 

 

Suppose you bought a new apartment for Rs.30 Lakhs in April 2010 and sold it in April 2014 for Rs.45 Lakhs. Your capital gain would be Rs.15 Lakhs.

 

The CII for the financial year 2010 in which the apartment was purchased is 148. And the CII for the financial year 2014 in which the apartment was sold is 220. 

 

Therefore, the CII is 220/148 = 1.48

 

When tax is computed, the CII is multiplied by the price at which the apartment was purchased to derive the indexed acquisition cost. This gives the actual cost of the capital asset. 

 

Hence, the indexed acquisition cost = 30,00,000 X 1.48 = Rs.44,40,000

 

Thus, the long term capital earnings derived by subtracting the indexed acquisition cost from the sale value of the capital asset will be: 45,00,000 - 44,40,000 = Rs.60,000

 

By using the indexation method, the tax that will be charged is 20%. 

Hence, 20% X 60,000 = 12,000 

 

But if you do not make use of the indexation method, the tax that you will be liable to pay on your capital earnings is 10%. In this case, the capital earnings are derived by subtracting the acquisition cost from the selling price of the capital asset which is, 45,00,000 - 30,00,000 = 15,00,000. 

Therefore, with 10% tax, 15,00,000 X 10 = Rs. 1,50,000 

 

Thus, the indexation method helps you save up on taxes by altering the price at which the capital asset was purchased with the price that is currently in the market. 

 

Additionally, you can make use of the cost inflation index calculator and obtain your CII by entering details such as purchase year, purchase amount, sales year and sales amount. 

The cost inflation index chart also known as the cost inflation index table, uses 2001-2002 as its base year wherein the CII value is fixed at 100. A glance at the indexation chart or indexation table will give you an idea of how the prices of services and goods have gradually increased over time. 

 

Given below is the cost indexation table from financial year 2001-2002 to financial year 2022-2023: 

It is imperative to CII and determine the CII since indexing assists in saving a significant amount on income tax that would otherwise be levied on the long term capital earnings from the selling of your capital assets. Using this, you can reduce the tax to be paid on the long term capital earnings that you acquire from the selling or transfer of capital assets like real estate, debt mutual funds, etc, by modifying the total amount that you invest according to the CII of the years of the asset’s purchase and sale. Hence, by implementing the cost inflation index on your capital earnings over a long term, you can earn a surplus post tax payments that can be further invested in other financial assets. 

Although the Cost Inflation Index is a useful tool for determining cost indexation rates, it has a few limitations. The benefits of the CII are not applicable in the case of debentures or bonds. The exceptions to this rule are the sovereign gold bonds or the capital indexation bonds issued by the Reserve Bank of India.

 

Additionally, if you have invested any amount in the improvement of your capital asset, that amount will not be liable for indexation. Furthermore, the indexation is not applicable for short term capital earnings. The indexation benefit is also not accessible to Non-Resident Indians.