In an economy, the prices of products rise with time which results in the fall of the consumer’s purchasing power of money. By purchasing power, we refer to the quantity of products that certain units of money can buy. Suppose 3 units of a particular product could have been bought last year for Rs 100. Whereas, this year you can only buy 2 units of that product with Rs. 100. This is caused due to inflation.

Cost inflation Index (CII) is a measure used to calculate the estimated rise in the price of a product or an asset on a yearly basis because of inflation. CII is calculated to match the prices of products to the economy’s inflation rate. In simple words, there will be an increase in prices of products with rise in inflation rate.

Who estimates the cost inflation index ?

The cost inflation index is specified by the central government by information through the official gazette. Cost inflation index is basically 75% of the average increase in the urban Consumer Price Index (CPI). Here, Consumer Price Index refers to the comparison of current price of basket of goods and services with the price of the same goods and services from the previous year in order to estimate the increase in prices.

Cost Inflation Index over the years

How is Cost Inflation Index used in Income Tax ?

Long-term assets are recorded in the books at their cost price. Even though there is inflation through the life of the asset, these assets exist on the books at the same cost price and cannot be adjusted for inflation. Because of this, when these long-term assets are sold, they sell at a higher amount because of higher sale price as compared to the cost price. These leads to a higher income tax because of more profit.

In order to reduce the tax and benefit the taxpayer, CII is applied on long-term assets. The purchase price of the asset is adjusted as per the increase in the inflation from the year of purchase to the year of sale of the asset. This adjustment results in lesser taxes due to lesser profit.

Let’s understand this with the help of an example. Let’s assume Mr. Y buys a plot of land with the idea to resell it at a late date for a profit. He buys this land at a price of Rs. 10,00,000 in the year 2005-2006. In the year 2014-15, Mr. Y sells the land for a consideration of Rs. 25,00,000. Normally, the tax computation for Mr. Y’s transaction should be on an income of Rs. 15,00,000 (Rs. 25,00,000 – Rs. 10,00,000). However, this is not the case. If you refer to the table earlier, you will see the index had a value of 117 in the year 2005-06 when the land was purchased. However, in the sale year 2014-15, this index had risen to 240. So, we must adjust the purchase price upwards in order to compensate for the inflation. To do this, we simply divide the current year index number with that of the base year and multiply the result with the original purchase price. Therefore, in this case the purchase price would be 240/117 x 10,00,000. This is equal to Rs. 20,51,282. The tax is only payable on an income of Rs. 4,48,718 (Rs. 25,00,000-Rs. 20,51,282).

What is the concept of base year in Cost Inflation Index ?

Base year is the initial first year of the Cost Inflation Index which has an index value of 100. Base year is used as a benchmark for comparison for index of other years to witness the rise in inflation rate. For any capital asset purchased, an individual should always take into account the base year of CII of that asset. As in future, at the time of selling, it will give the indexation benefits, which is only applied to the purchase price. The current base year has shifted to 2001 from 1981, as the taxpayers were facing issues in valuation of property prices.

Application of Inflation in Mutual Funds

If you have invested in mutual funds or have read about the tax on mutual funds you would have surely come across the word indexation. What is indexation? Let’s understand this in detail.

Firstly, let’s categorize mutual funds into 2 broad types – equity and debt. There is no application indexation or the cost inflation index in the gains from equity mutual funds. In the case of debt mutual funds, taxes on capital gains are of 2 types – short term (for units held for less than 3 years) and long term (for units held for more than 3 years). The benefits of indexation are only applicable for debt funds held more than 3 years. The tax rate on the gain from such proceeds is 20% with the benefit of indexation.

Example: Mr. C bought 1000 units of a debt fund on 18th August 2009 at a NAV of Rs. 24.50 per unit. On 30th December 2012 he sold all 1000 units at a NAV of Rs. 36.25. Since his holding is greater than 3 years the tax applicable is for long term capital gains. We shall now refer the table above to adjust his purchase price for inflation. In 2009-10 when he bought the units the CII was at 148. In the year of sale, which is 2012-13, it had risen to 200. So, the adjusted purchase price per unit would be 200/148 x 24.50 = Rs.33.11. The capital gains would now be Rs. 8.61 (Rs. 33.11 – Rs. 24.50). This would be taxed at a rate of 20%. Therefore, total tax payable by Mr. C is 1000 x 8.61 x 20% = Rs. 1,722.

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