What is Cost Inflation Index (CII)? Concept, Benefits Explained

The Cost of Inflation Index (CII) or the CII index states the level of inflation for the current Financial Year and is issued by the Income Tax (IT) Department in every year's budget. They are important for calculating the changes in the value of assets that we purchased in previous years but are selling in the current year. It is a three-digit figure used to determine the overall calculation.

Example - We purchased a house for ₹20,00,000 but now we are selling it for ₹30,00,000 in the current year. Here, our profit may seem to be ₹10,00,000 but it is not an accurate profit. The reason is the increased rate of inflation because of which ₹20,00,000 in the past is of higher value than ₹20,00,000 today. Some may say that the current value is ₹17,00,000 while others say it is ₹25,00,000. To avoid this confusion and to bring a standardised value, the Income Tax Department has introduced the Cost Inflation Index for easier calculation of long-term gains. The CII is issued by them every financial year in the yearly Budget. Currently, the base year taken is 2001. 

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What is CII Index all about?

The CII index is used to calculate an asset's value after adjusting the inflation with its cost price. The Long term capital gains/ losses (LTCG/ LTCL) of any asset or investment are calculated using this price after adjusting for inflation. Calculation of values of assets that include buildings, lands, mutual funds, gold jewellery, and houses is done using the CII figure. However, you cannot use it to compute gains/ losses on equities, mutual funds and equity shares (amount above ₹1 Lakh) taxed at a 10% rate without any benefit of indexation. 

Inflation and Capital Gains

To understand the concept of indexation, first, we need to understand the concept of inflation and capital gains.

• Inflation - Inflation means the decline in the purchasing capacity of an individual of any given currency within a given period of time, against the increase in the worth of products. For example, you will be able to buy a property in Delhi with ₹10 Lakh in 1970. But the same amount is not sufficient to buy a property in the year 2023. This is because the worth of ₹10 Lakh has declined and the value of properties has increased over the decades. Hence, inflation decreases an individual's purchasing capacity.
• Capital Gains - The capital gain for any asset or investment refers to the appreciation in the value of products over a period of time. It can be long-term or short-term depending on the period of holding of that asset.

Indexation - Meaning

With the indexation method, you can reduce your liability for tax on long-term gains. In this method, the cost of the asset is increased as per the current inflationary trend. The selling price of the asset is deducted from the inflation-adjusted price. The difference amount is the long-term capital gain or loss. The cost of acquisition' is a historical value used to calculate short-term capital gains. Whereas, the indexed cost of acquisition (ICOA) reflects the impact of inflation on cost.

Benefits of Indexation:

The benefits of the cost of indexation are as follows:

• Reduced taxable capital gain - The indexation method appreciates the cost price of the asset, hence reducing the taxable gain that you will receive.
• Makes investments profitable - Indexation makes investments a profitable scheme since it gives the investors a good opportunity to earn profits even after-tax returns.
• Reduced tax liability - Since the taxable capital gain gets lowered, so is your liability for tax.
• Regulates the purchase price of an investment - Since the indexed cost of acquisition takes inflation into account, it also regulates the original price of the investment as per the inflationary trend.
• Increased disposable income - Since the reduction in tax liability will mean more amount left in your hand, you can invest or buy more to develop your goals.

Indexation Chart:

Here is the indexation chart from the FY 2001-02 till 2022-23 (base being 2001-02 and cost of indexation for FY 2022-23 being 331):

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Calculation of Long Term Capital Gains (LTCG) Using Indexation

To understand how the concept of indexation works in capital gains, we first need to understand the formula for the calculation of taxable capital gain. The formula to calculate the taxable capital gain of an asset or investment is:

Taxable capital gain/ loss (long-term) = Sale price asset or investment - Indexed Cost of Acquisition (ICOA) asset or investment

Now, ICOA = Cost price of the asset (original) * (CII in the year of sale of the asset or investment/ CII in the year of purchase of the asset or investment)

The base year is taken as 2001-02 and its index is 100. Refer to the above chart to know about the capital gain index for any year. These values are published on the website of the Income Tax Department. 

Let us understand the concept of Indexed Cost of Acquisition with the help of an example:

Example 1- Let's say the purchase price of an asset is ₹1,50,000 Lakh in June 2016 and the sale price in July 2021 is ₹2,00,000. 

• Cost Inflation Index for FY 2016-17 = 264
• Cost Inflation Index for FY 2021-22 (year of sale) = 317
• Period of holding = 6 years

Solution - ICOA = Cost price of the asset (original) * (CII in the year of sale of the asset or investment/ CII in the year of purchase of the asset or investment) = 1,50,000 * (317/ 264) = ~₹1,80,114

The redemption price for the asset = ₹2,00,000

Taxable capital gain (long-term) = ₹2,00,000 - ₹1,80,114 = ~₹19,886

Here, you can see that you are not paying tax on ₹50,000 (₹1.5 Lakh - ₹1 Lakh) but on ₹19,886 only.

Let us look into another example for better clarity:

Example 2 - The purchase price of an asset is ₹2 Lakh in September 2007 and the sale price for the same is ₹7 lakh in August 2023.

• CII for FY 2007-08 = 129
• CII for FY 2022-23 = 331
• Period of holding = 15 years

Solution - ICOA = Cost price of the asset (original) * (CII in the year of sale of the asset or investment/ CII in the year of purchase of the asset or investment) = 2,00,000 * (331/129) = ~₹5,13,178

The sale value for the asset = ₹7,00,000

Taxable capital gain (long-term) = ₹7,00,000 - ₹5,13,178 = ₹1,86,822

Here, you will be paying tax only on ₹1,86,822 and not on ₹5 Lakh (₹7 lakh - ₹2 Lakh). 

Indexation in case of Debt Mutual Funds

The most common use of indexation benefit is to calculate the taxable gains from mutual funds. If they are held up to 36 months, then they are to be computed as STCG. If you hold them for more than 36 months, they are to be computed under LTCG on which indexation benefit is available. Tax on such transactions is charged at the rate of 20% with the benefit of indexation.

In the above example 1, if the taxable capital gain is ₹19,886, then the tax amount would be charged as 20% of ₹19,886, which equals approx ₹3,977.

In the Budget of 2017, the Government declared that the base year is changed from 1981 to 2001. This was done because there were many challenges obtained to get the appropriate information from the taxpayers. If the asset is purchased before 1st April 2001, then the purchase price of the asset will be the FMV (Fair Market Value) as of 1st April 2001.

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Conclusion:

Indexation helps us to reduce the capital gain value subjected to tax. This further reduces your liability for tax and helps you to save tax. Hence, understanding the indexation concept is really beneficial. Use the above-mentioned formula to compute your cost of acquisition with indexation benefit. You can also take advice from your tax consultant to know more about the benefits of indexation. Use this technique that the Income Tax Act gives you to bring a reduction in your taxable income. 

Make your investment in those funds that offer you this benefit of indexation, so that you can plan all your investments and taxes accordingly. 

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