What is cost inflation index and indexation ?

What is cost inflation index and indexation ? To understand indexation, let us quickly see what we mean by capital gains. If you sell an asset such as real estate, stocks, mutual funds, jewelery etc, you earn a profit from such a transaction. This profit is called capital gain. If you sell an asset after 36 months from date of purchase, the profit you make is called long term capital gain. If you sell an asset within a year of its sale, the profit you make is called short term capital gain. There are exceptions to these definitions but then this is an article on indexation !

However, like a nagging housewife who does not want to let go of  her husband’s wallet, the government does not want to let go of its share in our monetary happiness – it wants us to share our capital gain in the form of capital gain tax which it levies. So, the tax you pay on your capital gains is called capital gains tax. Let us see the formula for capital gains (not capital gain tax).

Capital Gains = Full Value of Sale – Indexed Cost of Acquisition – Indexed Cost of Improvement – Any exemptions

Indexed Cost of Acquisition = Cost of acquisition * Cost Inflation  Index (CII)

Full value of sale is the actual cost at which the asset is sold. Note the word “indexed” in the formula above. Note the formula for indexed cost of acquisition. For this article let us forget Indexed Cost of Improvement and  exemptions so that it becomes easy  for us to understand indexation.

The cost of acquisition is nothing but the cost of purchase. Let us see what CII is.

Concept of Indexation

The value of a rupee today is not same as the value of a rupee tomorrow. The prices of basic essentials keep on rising, thanks to a factor called inflation. So, if it is fare to pay more for toothpaste over the years because of price rise (inflation), is it fair to pay capital gain tax without incorporating the effect of inflation on your purchase?

Let us understand this question first with an example.

Suppose you bought an apartment (capital asset) in January 2000 for Rs 20,000,00/- (purchase price) and sold it in January 2009 for Rs 35,000,00/- (sale price). Your profit (capital gains) on the deal is Rs 15,000,00/- (sale price minus purchase price). Should you pay capital gain tax on this entire amount ?

Thankfully, the taxman has a big heart as far as this matter is concerned. He lets you apply a concept called indexation so that you can show a higher purchase cost of the capital asset you bought which in turn lowers the overall profit and hence the tax that you pay to the government – and yeah, it’s legal!

Why Indexation ?

The idea is that inflation reduces the asset value over a period of time and so the government is kind enough to allow us to jack up the purchase price of the asset and reduce the profit and hence the tax that we have to pay to it.

Indexation helps us to counter the erosion in the value of the asset over a period of time. Using the inflation index, one needs to increase the purchase price of the asset so that it reflects inflation-adjusted true price in the year in which it is sold.

How is indexation used in calculations – introducing Cost Inflation Index (CII) ?

In indexation and capital gain parlance, the purchase price is called indexed cost of acquisition. This means that the acquisition price (purchase price) is indexed by some factor. This factor is called the Cost Inflation Index (CII).

Let us see the formula for CII.

Cost Inflation Index (CII) =

(Cost Inflation Index (CII) for year in which asset is transferred or sold) / (Cost Inflation Index (CII) for year in which asset was acquired or bought)

The government publishes the indexation data for all the years. Here it is.

Cost Inflation Index for all years

In the example above, the year in which asset is transferred or sold is 2009 and the Cost Inflation Index (CII) for 2009 = 582

The year in which asset is acquired or bought is 2000 and the Cost Inflation Index (CII) for 2000 = 389

So the Cost Inflation Index (CII) = 582 / 389 = 1.49

The Cost Inflation Index (CII) is then multiplied with the purchase price to arrive at the indexed cost of acquisition which is the actual or true cost at the time of tax computation/calculation.

So, in the example above, the indexed cost of acquisition = 20,000,00 * 1.49 = Rs 29,92,288

Hence, long term capital gain = full value of sale – indexed cost of acquisition

= 35,00,000 – 29,92,288 = Rs 5,07,712

Tax liability on capital gain with indexation and without indexation

In case of long term capital gains, the tax liability is the lower of the amount arrived at by the two methods below :

# 20% tax liability arrived at by indexation method

# 10% tax liability arrived at by without using indexation method

In the example above, using indexation, the tax liability comes to (20/100) * 5,07,712 = Rs 101,542

If you were to not use indexation,

capital gains = sale price of asset – cost of acquisition = 35,00,000 – 20,00,000 = Rs 15,00,000

Capital gains tax on this at 10% = (10/100) * 15,00,000 = Rs 1,50,000

This is around 48% of what you would pay when you were to use indexation. So obviously, using indexation is better as you benefit in saving taxes.

So to recap :

• Indexation means incorporating the impact of inflation during the holding period of the capital asset by adjusting its purchase price so that the actual value of the asset is at par with the current market prices.
• The government publishes the inflation index factor each year.
• Indexation helps us to lower our capital gains tax.
• Indexation can be applied on improvements done to the house as well.
• Indexation calculations are different for properties passed on by inheritance.