A Brief – Cost Inflation Index and Taxation

Inflation can change the political scenario of a country. But what exactly is inflation in simple terms?

Let’s take an example to understand inflation better – Often, the price of a commodity increases over time which leads to fall in purchasing power of money i.e. if 7 items can be bought for INR 700 today, tomorrow you may be able to buy only 5 items at the same price on account of inflation. This brings us to the tax jargon i.e. Cost Inflation Index (‘CII’), which calculates the estimated rise in the cost of goods and assets year-by-year as a result of inflation.

What is the significance of CII and Indexation?

It is used for computation of Capital Gains and related taxes. If the index is not used, the inflated prices increase your gains and more gains result in increased tax liabilities. Therefore, the use of CII is beneficial for a taxpayer. The entire process of adjusting the cost price of a capital asset with the effect of inflation using the CII number is referred to as indexation under direct tax and other allied law. Also, whenever an asset especially house property is being reconstructed or renovated, such cost is treated as a cost of the improvement. This index is substantial for the reduction of taxes. It inflates the purchase price of the Capital asset, thereby reducing the capital gain which in turn reduces the amount of tax payable on the same. Also, the inclusion of the cost of improvement will further reduce the capital gains resulting in less tax liability.

Who notifies CII?

Each year CII is calculated by the Central Government of India and CBDT using the Consumer Price Index (CPI) for a given year and is disclosed before the Financial Year. Cost Inflation Index for FY 2018-19 i.e. AY 2019-20 was notified as 280.

Updates on CII

Budget 2017 proposed major amendments in provisions relating to indexation for the purpose of determining long term capital gains. Base year was shifted from FY 1981-82 to FY 2001-02.  Initially, 1981-82 was considered as the base year. But both the taxpayers as well as the tax authorities were facing hardships in getting the properties valued and relying on the valuation reports respectively. Hence, the government decided to shift the base year to 2001 so that valuations can be done quickly and accurately. In respect of assets acquired prior to 1 Apr. 2001, the assessee now has the option to use FMV/ Indexed Cost of Acquisition for arriving at the figures of long-term capital gains, providing property investors with a fair chance to gain in most of the cases.

A lot of Direct tax case laws under the Capital Gain chapter revolve around the issue of Indexed cost of acquisition and evading of taxes by misinterpreting the indexation provisions.