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Prices of goods increase over time, resulting in a fall in the purchasing power (quantity of goods that one unit of money can buy) of money. If two units of goods could be bought for Rs 100 today, tomorrow only one unit might be available for Rs 100 due to inflation. Cost Inflation Index (CII) is used to estimate the increase in the prices of goods and assets year-by-year due to inflation.
Cost Inflation Index is calculated to match the prices to the inflation rate. In simple words, an increase in the inflation rate over time will lead to a rise in the prices.
The Central Government specifies the cost inflation index by notifying in the official gazette.
Cost Inflation Index = 75% of the average rise in the Consumer Price Index* (urban) for the immediately preceding year.
*Consumer Price Index compares the current price of a basket of goods and services (which represent the economy) with the cost of the same basket of goods and services in the previous year to calculate the increase in prices.
|Financial Year||Cost Inflation Index (CII)|
|2001-02 (Base year)||100|
Long-Term Capital Assets are recorded at cost price in books. Despite increasing inflation, they exist at the cost price and cannot be revalued. When these assets are sold, the profit amount remains high due to the higher sale price as compared to purchase price. This also leads to a higher income tax. The cost inflation index is applied to the long-term capital assets, due to which purchase cost increases, resulting in lesser profits and lesser taxes to benefit taxpayers. To benefit the taxpayers, cost inflation index benefit is applied to the long-term capital assets, due to which purchase cost increases, resulting in lesser profits and lesser taxes.
The base year is the first year of the cost inflation index and has index value as 100. Index of all other years is compared to the base year to see the increase in inflation percentage. For any capital asset purchased before the base year of cost inflation index, taxpayers can take the purchase price as higher of the “actual cost or Fair Market Value (FMV) as on 1st day of the base year. Indexation benefit is applied to the purchase price so calculated. FMV is based on the valuation report of a registered valuer.
Initially, 1981-82 was considered as the base year. But, taxpayers were facing hardships in getting the properties valued which were purchased before 1st April 1981. Tax authorities were also finding it difficult to rely on the valuation reports. Hence, the government decided to shift the base year to 2001 so that valuations can be done quickly and accurately. So, for a capital asset purchased before 1st April 2001, taxpayers can take higher of actual cost or FMV as on 1st April 2001 as the purchase price and avail benefit of indexation. You can read detailed benefits of the change in the base year here.
When the indexation benefit is applied to “Cost of Acquisition” (purchase price) of the capital asset, it becomes “Indexed Cost of Acquisition”.
Case 1: Rahul purchased a flat in FY 2001-02 for Rs. 10,00,000. He sells the flat in FY 2017-18. What will be the indexed cost of acquisition?
In this case, CII for the year 2001-02 and 2017-18 is 100 and 272 respectively.
Hence, the indexed cost of acquisition = 10,00,000 x 272/100 = Rs. 27,20,000
Case 2: Shivani purchased a capital asset in FY 1995-1996 for Rs. 2,00,000. FMV of the capital asset on 1st April 2001 was Rs. 3,20,000. She sells the asset in FY 2016-17.What is the indexed cost of acquisition?
Here, the asset is purchased before the base year.
Hence the cost of acquisition = Higher of actual cost or FMV on 1st April 2001. i.e. cost of acquisition = Rs. 3,20,000.
CII for the year 2001-02 and 2016-17 is 100 and 264 respectively.
Indexed cost of acquisition = 3,20,000 x 264/100 = Rs. 8,44,800
Case 3: Gita has purchased equity shares of Rs. 1,00,000 on 1st March 2015 and sells the shares on 1st April 2020. What will be the indexed cost of acquisition?
CII for the year of purchase FY 2014-15 is 240 and
for the year of sale 2020-21 is 301
Hence, indexed cost of acquisition = Rs. 1,00,000 x 301/240 = Rs. 1,25,416