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 2 units of goods could be bought for Rs.100 today, tomorrow only 1 unit might be available for Rs. 100 due to increasing inflation.
Cost Inflation Index (CII) is used for calculating the estimated increase in the prices of goods and assets year-by-year due to inflation.
Why is Cost Inflation Index calculated?
Cost Inflation Index is calculated to match the prices to the inflation rate. In simple words, an increase in the inflation rate over a period of time will lead to an increase in the prices.
Who notifies the cost inflation index?
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 price of the same basket of goods and services in the previous year to calculate the increase in prices.
What is the current Cost Inflation Index?
How is Cost Inflation Index used in Income Tax?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.
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.
What is the concept of base year in Cost Inflation Index?
The base year is the first year of Cost Inflation Index and has index value as 100. Index of all other years is compared to 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.
Why is the base year of Cost Inflation Index changed to 2001 from 1981?
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.
How is indexation benefit applied to long-term capital assets?
When the indexation benefit is applied to “Cost of Acquisition” (purchase price) of the capital asset, it becomes “Indexed Cost of Acquisition”.
Points to Ponder
- In case of property received in the will, CII has to be taken for the year in which the property is received. Actual purchase year of the property has to be ignored.
- Ignore the improvement cost incurred before 1st April 2001.
- Index benefit is not allowed in case of bonds or debentures except capital indexation bonds or sovereign gold bonds issued by RBI.
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.