Cost Inflation Index is defined as a measure of inflation which is usually used for calculation of long term capital gains from the sale of capital assets. In simple terms, Cost Inflation Index is an index with 100 as its base which computes long term capital gains. It calculates the estimated increase in the price of goods and assets every year due to inflation. It is useful in finding out the indexed cost of a capital asset like mutual funds, property, etc.
The process where in the price of capital assets are adjusted with the effect of inflation by using the Cost Inflation Index number is known as indexation.
Capital Gain is the net profit which an investor can obtain after sale of any of his capital asset at a price which is higher than the Original price of purchase. The entire value obtained by the sale of the capital asset is taxable under the Income Head ‘Income from capital gains’. Capital Gains are not applicable for assets which are inherited or are acquired by gift or partition.
Land, building, vehicles, patents, leasehold rights, machinery, etc. are examples of Capital Assets. Capital Assets can also include company rights, right of management control or any other legal rights as well.
What is the need to calculate Cost Inflation Index?
Due to an increase in the rate of inflation over a particular time period, there will also be an increase in the prices of goods and assets. The Cost Inflation Index will carry out the task of matching the prices of goods and assets with that of the rate of inflation.
Who is responsible for the notification of Cost Inflated Index?
The Central Government notifies the Cost Inflation Index in its official gazette to measure inflation. When the Central Government defines the Cost inflation index every year, it is defined by Section 48 of the Income Tax Act, 1961.
Cost Inflation Index can be represented as 75% of the average rise in the Consumer Price Index for the previous year.
We can define Consumer Price Index as a number which compares a collection of goods and services with the price of similar collection of goods and services in the preceding year. This will help in calculating the increase in prices of goods and services.
What is base year in Cost Inflation Index?
Base Year is defined as the first year of the Cost Inflation Index and is with an index value 100. The index of all other years can be compared with the base year to have an idea on the percentage of inflation.
Capital Assets which were purchased before the base year of Cost Inflation Index, taxpayers can consider the purchase price as higher out of ‘Fair Market Value’ or the actual cost as on the 1st day of the base year.
Why base year of Cost Inflation Index has been changed?
In the starting period, 1981-82 was considered as the base year. But, soon it was realized that taxpayers were having difficulties in getting those properties valued which were purchased before 1st April 1981. It was quite difficult for the tax authorities to trust on the valuation reports.
So, due to these reasons Government decided to shift the base year to 2001 so as to get the valuations done correctly. By shifting of base year, it is feasible to capture the asset’s inflated cost in a perfect way and would also help in reducing the tax burden.
Cost Inflation Number for the Financial Year (FY) 2018-19
The Government declares the Cost Inflation Index value for each year by considering the inflation that has occurred in the country. The Cost Inflation Number for the Financial Year (FY) 2018-19 is 280.
How to calculate Cost Inflation Index?
The simple formula to calculate Cost Inflation Index is represented below i.e.
Cost Inflation Index (CII) =CII for the year in which the asset was transferred or sold/ CII for that year in which the particular asset was bought or acquired.
Let us calculate Cost Inflation Index by an example.
Let say, suppose an apartment was purchased by you at Rs.20 lakhs in January 2000 and you sold it for Rs. 40 lakhs in January 2009. So, now your profit or in other words your capital gain =Rs. 20 lakhs.
The CII for that year in which the apartment was bought is 389 and the CII for the year in which the apartment was sold is 582.
So, now Cost Inflation Index= 582/389=1.49
Now, we can find out the Indexed Cost of Acquisition by multiplication of Cost Inflation Index with the price at which the asset was purchased. This Indexed Cost of Acquisition is the actual cost of the asset.
Indexed Cost of Acquisition= 20, 00,000 x 1.49=Rs. 29, 92, 288
Now, from this we can also find out the Long term capital gain.
Long term capital gain=sale value of the asset-indexed cost of acquisition=Rs. 40, 00,000-Rs. 29, 92,288=Rs. 10, 07,712
If you are using the indexation method, the tax liability is 20%. The tax liability will be 20% x 10, 07,712= Rs. 201542.40
Suppose, you are not using the indexation method then the tax liability is 10% of capital gain.
Here, Capital Gain=Sale price of the apartment – Cost of the apartment when bought= Rs.40, 00,000-Rs.20, 00,000=Rs. 20, 00,000
Tax Liability=10% x 20, 00,000=Rs, 2, 00,000
Tool to calculate LTCG
There are a large number of tools available online which can be used to calculate the Long Term Capital Gains and observe how much profit is to be obtained from the sale of the asset.
The Long Term Capital Gain Calculator usually asks for certain details like the purchase price, sale price, etc. and the individual can see the profit gained.
However, the calculation of LTCG can be done manually as well.
Mr. Mehta bought a property at the price of Rs.60 lakhs in the year Sep’04. After 10 years, Mr. Mehta decides to sell the property at Rs.1.5 crores. Since the asset is a long term asset the cost needs to be indexed to find out the capital gains.
So, the cost of calculating Capital Gains will be Rs. 60 lakhs x CII of 2014-15 /CII of 2004-05. This will be equal to Rs.1.28 crores. Hence, the net gain obtained is RS.22 lakhs.
Use of Cost Inflation Index in tax reduction
By the indexation method, the amount of Income Tax that will be levied on long term capital gain can be easily determined. However, this indexation method is not available for short term gains, short term losses and for Non-Resident Indians.
The method of indexation for long term capital gain can be obtained only if the below- mentioned criteria are met.
The cost of acquisition of the asset needs to be multiplied with the cost of inflation of that year in which it was transferred. Then the figure obtained needs to be divided by the cost inflation index for that year in which the asset was acquired. Suppose, the asset was bought in 1861, then the CII for the year 1861 needs to be used while doing the calculations. If there have been any improvements in the asset by multiplying the CII with the CII of the year in which the improvements were made.
Hence, the value of rupee keeps on changing every single day. Similarly, the prices of other items also keep on changing. Since we do not believe in paying extra amount for any items, it is also not fair to pay Capital Gains Tax without analyzing many factors related to taxation.
So, the Cost Inflation Index will measure inflation and also help in reducing the liabilities related to Income Tax.