The Cost Inflation Index (CII) is a tool issued by the government to measure the rise in prices of goods and services over time. It plays a key role in adjusting for inflation when calculating capital gains.
When you sell an asset, such as real estate or shares, the profit earned is subject to capital gains tax. However, because inflation erodes the value of money over time, the CII allows you to adjust the original purchase cost of the asset, reflecting its inflation-adjusted value. This adjustment helps lower the taxable capital gains amount.
In simple terms, the CII ensures that taxpayers are taxed fairly by accounting for the impact of inflation on asset values.
What is the Cost Inflation Index (CII)?
The Cost Inflation Index (CII) is a measure used to account for inflation when calculating gains on long-term assets like property, gold, and debt mutual funds. It reflects the rise in the prices of goods and services over time. Issued annually by the Central Board of Direct Taxes (CBDT), the CII helps adjust the purchase price of assets to their inflation-adjusted value, ensuring a fair calculation of taxable capital gains.
New Cost Inflation Index (CII) Table for Financial Years
The updated CII values for the financial years 2021-22 and the proposed value for 2022-23 are as follows:
Financial Year 2021-22: 317
Financial Year 2022-23 (Proposed): 344
How is the Cost Inflation Index (CII) Used in Income Tax?
The Cost Inflation Index (CII) is an important tool in income tax for adjusting the purchase price of an asset to account for inflation over time. This process, known as indexation, helps ensure that the capital gains tax is calculated based on the inflation-adjusted purchase price rather than the original cost. As a result, when a long-term asset like property, gold, or mutual funds is sold, the taxable gain is reduced, leading to a lower tax liability.
Long-term capital assets are typically recorded in financial records at their original purchase price and are not revalued for inflation. Over time, due to rising prices, the selling price of these assets generally increases, often resulting in a higher apparent profit and, therefore, a higher tax burden when sold.
To address this, the Cost Inflation Index is applied. By adjusting the purchase cost according to inflation, indexation effectively reduces the taxable profits. This adjustment helps taxpayers by increasing the acquisition cost, thereby lowering the taxable capital gains and reducing the amount of income tax payable.
In short, CII acts as a tax relief measure, ensuring that taxpayers are not unfairly taxed on gains that are purely due to inflation.
Who Notifies the Cost Inflation Index?
The Cost Inflation Index (CII) is notified by the Central Government through a publication in the Official Gazette. It is calculated based on 75% of the average rise in the Consumer Price Index (Urban) for the immediately preceding year.
The Consumer Price Index measures the change in the price of a standard basket of goods and services over time, reflecting inflation across the economy. By linking CII to CPI, the government ensures that asset valuations fairly reflect inflationary trends.
How is Indexation Benefit Applied to Long-Term Capital Assets?
Indexation allows taxpayers to adjust the purchase price of a long-term capital asset for inflation, reducing the taxable capital gains. Here’s how the process works:
Determine the Cost of Acquisition:
This includes the actual purchase price and any incidental expenses like brokerage fees, stamp duty, legal charges, etc.Identify the Relevant CII:
CII for the Year of Acquisition (year the asset was purchased)
CII for the Year of Sale (year the asset is sold)
Calculate the Indexed Cost of Acquisition:
Use the formula:Indexed Cost of Acquisition = (Cost of Acquisition) × (CII of Year of Sale) ÷ (CII of Year of Acquisition)
Determine Indexed Long-Term Capital Gains:
Subtract the Indexed Cost of Acquisition from the Sale Price:Capital Gains = Sale Price – Indexed Cost of Acquisition
Apply the Tax Rate:
Long-term capital gains are taxed at a concessional rate, generally lower than short-term gains.
Indexation for Cost of Improvement
When you make improvements to an asset, the cost of those improvements can also be adjusted for inflation. The formula is:
Indexed Cost of Improvement = (Actual Cost of Improvement) × (CII of Year of Sale) ÷ (CII of Year of Improvement)
Where:
Actual Cost of Improvement is the expense incurred for enhancing or upgrading the asset.
CII of Year of Improvement is the index for the financial year when the improvement was made.
Including the indexed cost of improvement increases the cost base, further reducing taxable capital gains and providing a more accurate reflection of the asset’s true value over time.
How is the Cost Inflation Index (CII) Useful in Reducing Tax?
ndexation significantly reduces tax liability on long-term capital gains by adjusting the cost of acquisition and improvement of assets for inflation. However, indexation benefits do not apply to short-term capital gains or losses, and Non-Resident Indians (NRIs) are generally ineligible for this benefit.
To avail of the indexation benefit, the following process is followed:
Multiply the asset’s original cost of acquisition by the CII for the year of sale.
Divide this figure by the CII for the year of acquisition.
(For assets purchased before 1981, the CII of 1981 should be considered.)If improvements were made, their costs are adjusted separately using the respective year’s CII.
Why is the Cost Inflation Index Calculated?
The CII is calculated to adjust the acquisition and improvement costs of long-term assets, ensuring that taxpayers do not pay tax on inflationary gains. It reflects the rise in the general price levels over time, thus offering relief from paying higher taxes merely due to inflation.
Why Was the Base Year of CII Changed from 1981 to 2001?
The base year was shifted from 1981 to 2001 to better reflect the changes in the economy, prices, and market dynamics. This update ensures that asset valuations are more realistic and relevant when calculating capital gains today.
How is Indexation Benefit Applied to Long-Term Capital Assets?
The indexed cost of acquisition is calculated using the formula:
Indexed Cost of Acquisition = (Actual Cost of Acquisition) × (CII for the Year of Sale / CII for the Year of Purchase)
This indexed cost replaces the original cost when calculating long-term capital gains, significantly reducing the taxable gain.
How is the Cost Inflation Index (CII) Calculated?
CII is linked to the All-India Consumer Price Index (CPI) and is computed using the formula:
CII = (CPI of Current Year ÷ CPI of Base Year) × 100
What Should You Keep in Mind About CII?
CII applies only to assets eligible for indexation benefits.
Equity mutual funds do not get indexation benefits for gains above ₹1 lakh, which are taxed at 10% flat.
For FY 2024–25, CII will be needed for calculating LTCG where indexation is allowed.
CII is critical for adjusting costs and reducing taxable gains when filing ITR for FY 2024–25.
What Does the Base Year of CII Represent?
The base year (currently 2001–02, with an index value of 100) serves as the starting point for inflation calculations.
For assets acquired before the base year, the higher of the actual purchase price or Fair Market Value (FMV) as of April 1, 2001, can be considered.
The FMV must be determined through a registered valuer’s report
Significance of CII in Calculating Long-Term Capital Gains (LTCG)
Under Section 48 of the Income Tax Act, capital gains are computed by deducting:
Expenses incurred during the transfer
Cost of acquisition and cost of improvement (indexed where applicable)
Thus:
Indexed Cost of Acquisition = Cost of Acquisition × (CII of Year of Sale ÷ CII of Year of Purchase)
Indexed Cost of Improvement = Cost of Improvement × (CII of Year of Sale ÷ CII of Year of Improvement)
Indexation ensures that the gains reflect true economic profit by adjusting for inflation, thereby reducing the taxable amount.
Key Points to Remember About CII:
If an asset is inherited or gifted, the CII year is based on when the previous owner acquired the asset.
Costs of improvements made before April 1, 2001, are not eligible for indexation.
Bonds and debentures (except capital-indexed bonds issued by the government) do not qualify for indexation benefits.
How Indexation Reduces Tax Liabilities on LTCG
Since CII adjusts the acquisition cost upward, the net taxable capital gains decrease, which in turn lowers the tax liability.
This is particularly beneficial when selling:
Real estate
Debt mutual funds
Other long-term capital assets
Example:
If a property held for over 24 months is sold, the profit is classified as long-term capital gains and taxed at 20% after applying indexation. This adjustment reduces the taxable amount considerably compared to calculating gains without considering inflation.
This advantage is one reason for the popularity of investments like bond funds and Fixed Maturity Plans (FMPs), where investors can benefit from indexation and retain more after-tax returns.
