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What is the Cost Inflation Index (CII)?

Inflation is a part of the economy, and with each passing year, the purchasing capacity of money may be impacted by inflation. Simply put, what you buy today for ₹100 may be priced at ₹150 tomorrow. That's inflation. When it comes to long-term capital gains like the sale or transfer of assets, shares, bonds, land, etc., inflation can play a crucial role. 

Suppose you purchased a piece of land 10 years ago at ₹5 lakhs. Today when you go out to sell it, you may get ₹15 lakhs for it. However, when calculating inflation (suppose it is ₹5 lakhs for your land), the actual gain is ₹10 lakhs and not ₹15 lakhs. This calculation is done using the cost inflation index (CII). 

CII is a smart tool used by the government of India to calculate the inflation on long-term capital gains. It is used for the purpose of calculating the income tax on long-term capital gains. By using CII to adjust the gains on assets, the price and the tax liability are reduced to the current market rates. 

Note: In July 2024, the government of India announced the discontinuation of indexation benefits on long-term capital gains. Land and buildings purchased before 23rd July 2024 can choose between indexation benefit (with 20% LTCG tax rate) tax payment or without indexation benefit (at 12.5% LTCG tax rate).

Purpose of the Cost Inflation Index in Taxation

The purpose of the cost inflation index is simply to calculate the inflation over the years. If the inflation is not calculated, the taxpayers may end up paying more tax while the actual profit remains less. As discussed in the example above, without indexation benefit, the tax will be calculated on the ₹15 lakhs capital gains on the transfer of land. However, with indexation benefit, it may be at ₹10 lakhs, thus adjusting the tax value at the correct rate. 

What Does a Base Year in CII Mean?

The base year simply refers to the year from which the government calculates the inflation rate. When it comes to calculating indexation benefits for the taxpayers, the base year is taken into consideration, and the inflation after this year is calculated. In India, earlier, the base year in the cost inflation index was 1st April 1981. However, it was later changed to 2001.

This change in the base year was done since several taxpayers found it difficult to get details of properties and assets purchased before 1st April 1981. So, the government changed it to 2001 for quick and accurate inflation calculation.

How is Indexation Used for Long-Term Capital Assets?

The cost Inflation Index (CII) is applied to income tax in order to offset the effect of inflation on the worth of long-term capital property. Such properties, such as real estate or shares are booked in the ledgers at the initial cost, which does not fluctuate with time—though inflation goes up each year. When such an asset is sold or transferred, the difference between the sale value and the initial cost reflects a huge profit, leading to increased capital gains tax. 

In order to lower this tax, the CII is used. It raises the purchase price by using inflation figures released by the government. This reduction lowers the total profit or capital gain and, consequently, the tax liability. In brief, the CII prevents taxpayers from being unduly taxed on profits that are due only to inflation, not real profit.

Key Points on the Cost Inflation Index in India

Some of the highlights that you must remember about the cost inflation index in India are mentioned below:

  • The CII is a tool that measures the inflation rate and adjusts the capital gains accordingly for tax calculation

  • The current base year for indexation benefits is 2001

  • Depending on the inflation rate, the CII is also adjusted annually by the CBDT (Central Board of Direct Taxes) 

  • If the asset is received through a will, the cost inflation index is calculated from the year during which the previous owner purchased the asset

  • Since 1st April 2023, the indexation benefit is no longer applicable for debt mutual funds

  • Assets and properties purchased on or after 23rd July 2024 do not qualify for the indexation benefit. People who purchased land and buildings before this date can either pay LTCG tax at 12.5% (without indexation) or at 20% (with indexation benefit).

How Does Indexation Lower LTCG Tax Liabilities for Assessors?

Indexation reduces the Long-Term Capital Gains (LTCG) tax burden by making the purchase price of an asset inflation-indexed based on the Cost Inflation Index (CII). This makes the "indexed cost of acquisition" higher, thus lowering the tax-due capital gain. 

For instance, if a building was purchased years back, its cost is raised based on the CII values of the year of purchase and sale. The new cost accounts for inflation, and the profit looks lower, resulting in less tax. This approach helps taxpayers not pay a lot of gains that only occur due to inflation and not actual profit.

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