Cost Inflation Index is an index issued by Central Board of Direct Taxes, India, as a means of calculating the rate of inflation in an economy. It is used to calculate the long-term gains with respect to the sale of assets.
Capital Gains refers to the profit made on the sale of assets like jewelry, real estate etc. The capital earned from such profits is classified into two types; Short Term Gains and Long-Term Gains. If the asset is sold within a year of its acquiring, the profit from it is called Short Term Gains. If the asset is sold after 36 months from when it was bought, it is called Long Term gains.
The government of India extracts a tax on the Long Term Capital Gains with the help of Cost Inflation Index. This rating of the index changes every year.
There are different methods of calculating inflation index, some preferred over the other by the economists and investors.
Due to this, there are several Inflation Index Reports that are pursued, such as:
The Consumer Price Index (CPI) in India rose from 130.8 in March 2017 to 131.1 Index Points in April 2017. Consumer Price Index in India witnessed an all-time high increase of 131.4 Index Points in October 2016 and the lowest of 86.81 Index Points in February 2011.
To calculate the Cost Inflation Index the method employed is as follows:
1) Cost Inflation Index (CII) = CII for the year the asset was transferred or sold/CII for the year the asset was acquired or bought
2) For instance, in February 2002, an apartment was purchased for Rupees 15 lacs and sold in January 2017 for Rupees 45 lacs. In this case the profit or capital gained will be Rupees 30 lacs.
3) Suppose, the CII was 426 for the year the apartment was bought and the CII for the year the apartment was sold, is 1125.
4) The CII is 1125/426 = 2.64
5) The indexed cost of acquisition = Purchase value X CII. This is the actual cost of the asset.
6) Therefore, the indexed cost of acquisition = 15,00,000 X 2.64 = Rupees 39,60,000.
7) The long-term capital gain = selling price of the asset - indexed cost of acquisition i.e. 45,00,000 – 39,60,000 = Rupees 5,40,000.
8) If you use the indexation method, the tax is charged at 20 percent. The tax liability will be 20% X 5,40,000 = Rupees 1,08,000.
9) If you do not use the indexation method, the tax is liable at 10% on the capital gain. The capital gain here will be; selling price of the apartment – cost of acquisition = 45,00,000 – 15,00,000 = Rupees 30,00,000. The capital gains tax is 10% X 30,00,000 = Rupees 3,00,000.
10) Using index benefits you can save taxes.
11) This also helps you in adjusting the acquisition price on an asset to the current market value of the asset.
It is only available for long term gain if it meets the following criteria:
Cost Inflation Index (CII) for the year of sale/Cost inflation Index of year of improvement
CII of the year of Sale/CII of the year the asset was acquired
Cost Inflation Index considers the Consumer Price Index for the current year of non-manual employees for a preceding year. Usually, due to increase in prices of assets from the year they were bought, the government is authorized to levy heavy taxes on the sale of these assets. In the case of inflation sometimes the index may exceed the selling price of the asset. To avoid paying heavy duty taxes to Government of India, the sales price of an asset can be indexed to display the current value of the asset. In such case, its reduced value due to inflation can be accounted, in order to avoid heavy taxes levied by the government. Indexing the sales price of an asset will lower the selling price, thus, lowering the capital gains payable.
The index is used to determine the current market prices of the asset, with respect to the decline in its value because of inflation. When selling an asset, the indexed cost of acquisition is the price at which the asset is purchased. While, the cost inflation index (CII), is the indexed price at which the asset is purchased. For tax computation, the government fixes the CII for that year and releases it before the year ends. The Cost Inflation Index for the Financial Year 2016-17 was 1125.