Cost Inflation Index under Income Tax Act

Introduction

In an economy, with time, the value of money keeps decreasing, which leads to a notional increase in the cost/prices of all the commodities in that economy. The increase in price decreases the purchasing power of a person. In other words, with one unit of money, a person will be able to buy less and less of a commodity with time. This decline in the power of money, which ultimately increases the cost of living, is known as inflation. For instance, let’s suppose Ramesh was able to buy 10 mangoes with Rs. 100 in the year 2000; however, in 2020, he could only buy 2 mangoes with the same amount of money. This reduction in the power of Rs 100 to buy the same number of mangoes over time is due to inflation.

In case of long-term capital assets, it is very important to take into account the effects of inflation while calculating the capital gains tax under the Income Tax Act. Inflation not only increases the selling price of a capital asset but also makes the capital gains look large thus accounting for a large tax. This article intends to guide the readers about the impacts of inflation on long-term capital assets and how Cost Inflation Index saves the taxpayers from a huge capital gains tax. It also answers questions like: How to calculate capital gains with Cost Inflation Index? And How can one benefit from Cost Inflation Index from while calculating long-term capital gain tax on sale of property in India?

• What is Cost Inflation Index?

  The government of India has notified CII or Cost Inflation Index under Section 48 of the Income Tax Act, 1961. CII serves the purpose of calculating inflation, that is, an estimated increase in the price of commodities/capital assets over the years.

• How is CII Calculated?

  The Central Government calculates and publishes the CII in the official gazette. The following table presents the value of CII for the last 21 years.

• Notified Cost Inflation Index Under Section 48, Explanation (V)

  As per Notification No. 21 /2023/F.No.370142/5/2023-TPL-S.O. 1692(E), Dated 10-04-2023 following table should be used for the Cost Inflation Index:

Cost Inflation Index Table

• Government of India has only released the CII for the FY 2023-2024. Cost Inflation Index for FY 2024-25 will be released before the end this financial year. Therefore, Cost Inflation Index for FY 2024-25 will be released soon so that exact capital gains can be computated.

• CII is generally used for calculating long-term capital gains under Income Tax Act resulting from the sale of long-term capital assets such as land, bonds, stocks, housing property, etc.

• Cost Inflation Index = 75% of the average rise in the Consumer Price Index* (urban) for the immediately preceding year.

• *Consumer Price Index (CPI) compares and measures changes over the years in the general price levels of goods and services that the public uses for consumption purposes.

Role of Cost Inflation Index in Income Tax

Or

How to apply Cost Inflation Index in Capital Gains?

When a long-term capital asset is sold, its selling is naturally higher than the cost price due to a linear increase in the price of the asset over several years. Selling price also makes the profit larger and, in turn, leads to higher income tax on such profits. However, due to inflation, the profits are inflated - indicating less increase in the real selling price of the asset. To protect the taxpayers' gains from the effects of inflation, the government allows the Cost Inflation Index to be applied to the long-term capital assets, which increases the purchasing price of the assets in the books. This ultimately leads to lesser profits and lesser taxes, thus providing taxpayers with the benefits of real gains from the sale of their assets. The Government of India fixes the Cost Inflation Index annually before the end of a financial year.

• Concept of the base year in Cost Inflation Index

  The first year which is set as a base for the cost inflation index is known as the base year. The index of every other year and the increase in inflation is determined after comparing it to the base year. If any capital asset was purchased before the base year of cost inflation index, then the asset's purchase price will be valued at the actual cost or a "Fair Market Value"MV) as on the 1st day of the base year. The purchase price so arrived at will be used for calculating the indexation benefit. Although a registered valuer can be consulted for calculating FMV, nevertheless, there is no fixed formula for calculating the FMV of an asset. One of the widely used techniques for arriving at FMV is to compare the selling price of similar assets in the same location at that time.

• Change of the Base Year of Cost Inflation Index from 1981 to 2001

  The initial base year of 1981-82 was changed to 2001-02 for the convenience of the taxpayers as they were facing difficulties in the valuation of their assets purchased before 1st April 1981. Besides, the tax authorities did not find the valuation reports based on the previous base year as very reliable. So for an asset that was purchased before 1st April 2001, the taxpayer can either calculate an FMV as on 1st April 2001 or a higher value than the purchase price for availing the indexation benefit.

• Applying Indexation Benefit to Long-term Capital Assets

  Applying the indexation benefit to "Cost of Acquisition" (i.e., purchase price) of the capital asset turns it into "Indexed Cost of Acquisition."

• Formulae:

  Indexed Cost of Acquisition:

  = As per Notification No. 2336(E) [No. 73/2021 (F. No. 370142/10/2021-TPL)], Dated 15-6-2021 following table should be used for the Cost Inflation Index:

  Indexed Cost of Improvement:

  = (CII for the year of sale x Cost of Improvement)/CII for the year in which improvement to the capital asset were made

Important Points:

1. In case of property inherited through a will, CII has to be taken for the year in which the asset was received. Here the actual year of the purchase of the asset has to be ignored.
2. Any improvement cost added to the capital asset before 1st April 2001 has to be ignored too.
3. Debentures and bonds (except sovereign gold bonds issued by the RBI or capital indexation bonds) do not qualify for indexation benefit.

Illustrations:

Case I

Mrs. X purchased a house in FY 2001-02 for Rs. 20,00,000. She sold the house in FY 2017-18. Calculate the indexed cost of acquisition for the house.
Here, Cost Inflation Index for FY 2001-02 and 2017-18 are 100 and 272, respectively (See the Cost Inflation Index Chart). Therefore, the indexed cost of acquisition for Mrs.'s house = 20,00,000 x 272/100 = Rs. 54,40,000

Case II

Mr. Y bought a capital asset in FY 1995-1996 for Rs. 5,00,000. FMV of the asset as on 01-April-2001 was arrived at Rs. 7,20,000. Mr. Y sold the capital asset in FY 2016-2017. Determine the indexed cost of acquisition.
In this case, the capital asset was acquired before the base year. Therefore, the cost of acquisition will either higher of actual cost or FMV as on 01-April-2001.
Therefore, the cost of acquisition will be Rs. 7,20,000.
CII for the FY 2001-02 and 2016-17 are 100 and 264, respectively. Therefore, the indexed cost of acquisition = 7,20,000 x 264/100 = Rs. 19,00,800

Case III

Calculate the indexed cost of acquisition if Ram purchased equity shares of Rs. 2,00,000 on 01-March-2015 and sold them on 01-April-2020.
CII for the FY 2014-15 (year of purchase) and FY 2020-2021 (year of sale) are 240 and 301 respectively.
Therefore, the indexed cost of acquisition = 2,00,000 x 301/240 = Rs. 2,50,833

Case IV

Nitin purchased Sovereign Gold Bolds (SGB) in November 2015 at Rs. 4,00,000. He prematurely withdrew the bonds at the market price of Rs. 4,95,000 in January 2021. What is the indexed cost of acquisition for Nitin?
CII for the FY 2015-16 (the year of purchase) and FY 2020-21 (the year of sale) are 254 and 301, respectively.
Therefore, the indexed cost of acquisition = Rs. 4,00,000 x 301/254 = Rs. 4,74,016