One of the most important terms used in Income Tax, 1961 is Cost Inflation Index (CII). Understanding this term is very crucial for the correct computation of Long Term Capital Gains under Income Tax Act.
What is Cost Inflation Index?
Cost Inflation Index (CII) is a measure of inflation which is used in Income Tax Act, 1961 to compute long term capital gains on sale of capital assets. It comes under Section 48 of the Income Tax Act and is a quantifiable measure used to implement the concept of Indexation.
Cost Inflation Index from Financial Year 1981-82 to Financial Year 2016-17 is given below
|FINANCIAL YEAR||COST INFLATION INDEX|
Concept of Indexation
The value of rupee today is not same as it was some years back. The prices of commodities keeps on increasing due to a factor called Inflation. Hence the concept of Indexation is introduced in the Income Tax act to take into account, the effect of inflation while computing long term capital gain.
“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 Cost Inflation Index Used to calculate Long Term Capital Gains?
Cost inflation Index is reported in terms of Financial Year not in terms of Assessment Year. In India, the Financial Year starts from 1st April and ends on 31st March of the following year. To understand how CII is used, one should have a basic understanding of the following terms:-
- Capital Assets: A capital asset is defined as property of any kind held by an assessee, whether connected with their business or profession or not. It includes assets which can be held by a person for example Mutual Funds, Shares, Real Estate, Gold, Fixed returns Instruments such as Fixed Deposit, etc.
- Long Term and Short Term capital assets: Assets are classified as Long Term or Short Term with reference to the period of holding of the assets till it is transferred. The classification is made on the following basis.
|Nature of Asset||Short Term Capital Asset||Long Term Capital Asset|
|(i) Shares in a company or any other security listed in a recognized stock exchange in India or equity oriented mutual fund||Held for not more than 12 months.||Held for more than 12 months.|
|(ii) Assets other than assets mentioned in (i) above.||Held for not more than 36 months.||Held for more than 36 months.|
How does CII helps in computing capital gain/loss?
As the original cost of acquisition is historical, the concept of Indexation allows the tax payer to take into account the effect of inflation and consequently, a lower amount of capital gains gets to be taxed. In indexation and capital gain parlance, the purchase price is called Indexed cost of Acquisition. Following is the formula of Indexed Cost of Acquisition.
Indexed Cost of Acquisition = (Actual cost of purchase) * (CII of Year of Sale) / (CII of Year of Purchase).
This can be explained with the help of following example:
Suppose a property is purchased in financial year (FY) 1995-96 for Rs 20 lacs. It is sold in financial year 2016 -17 for Rs 100 lacs.
Then, the gain would be = Rs 100 lacs – 20 lacs = Rs 80 lacs.
But if CII is considered then we need to calculate cost of 20 lacs of 1995-96 in the year 2011-2012.
From the table Inflation index in year 1995-96 is 281 and year 2011-2012 is 1125.
So, Indexed cost of Rs 20 lacs in the year 2011-2012 is = 20 * (1125/281) = 80.07
Hence, Long term capital gain = 100 – 80.07 = 19.93 lacs instead of Rs 80 lacs.
However, Indexation cannot be used for all asset classes. The benefit of Indexation cannot be used for Fixed returns Investments such as Fixed Deposit, Bonds, Debentures, NSC, etc.