Cost Inflation Index: What is CII and How is it Calculated?

The price of commodities rises over time, reducing the purchasing power of money, which is the number of commodities that can be purchased in one currency. If you could buy two units for 100 rupees today, you may only be able to buy 1 unit for 100 rupees tomorrow due to inflation. The Cost Inflation Index (CII) estimates the annual rise in prices of goods and assets due to the inflation factor.

What is the Cost Inflation Index?

The world economy is dynamic and can change constantly. This change is reflected in the decline in purchasing power of money due to the sustained rise in prices of goods and services. The phenomenon of monetary depreciation that leads to higher personal living expenses is known as inflation. The Cost Inflation Index or CII is a tool used to calculate an estimated annual rise in asset prices due to inflation. 

The central government has set this indicator and published it in the official bulletin for measuring inflation. This index, reported annually by the Government, is defined in Section 48 of the Income Tax Act of 1961. Nowadays, there are lots of cost inflation index calculators available online. 

How is the Cost Inflation Index Calculated?

The asset’s price during the time of buying is indexed by the cost inflation index.

Cost Inflation Index = CII during the time asset was sold / CII during the time asset is acquired.

Example:

An individual bought a property for Rs. 20 lakhs in the year 2000; in 2009, he sold it for Rs. 35 lakhs. The profit made over the years till date is around Rs. 15 lakhs.

The Cost inflation index for the year 2000 was 389, and in the year 2009, the CII was 582.

Hence, the Cost Inflation Index is = 582 / 389 = 1.49

For Indexation of Long-term Capital Assets

Calculating the indexed asset acquisition cost,

Indexed Asset Acquisition Cost = (CII at the time the asset was sold X Acquisition Cost) / CII at the time asset is acquired

To calculate the asset improvement indexed cost,

Indexed Asset Improvement Cost = (CII during the time the asset was sold X Cost of Asset Improvement) / CCI during the improvement time.

Example:

An individual purchased an asset for Rs. 1 lakh in the financial year 1979-80. The Fair Market Value(FMV) in the year 2000 reached Rs. 2,20,000 for his property. He sold the property in the year 2015-16.

Note: The asset is purchased before the base year (2001). Hence the CII of the year 2001 will be considered, which is 100.

Also, the asset acquisition cost is always higher than the actual cost or Fair Market Value.

Therefore, the acquisition cost here is = Rs. 2,20,000

Indexed cost of acquisition = (254 X 2,20,000) / 100 = Rs. 5,58,000

Also Read: Consumer Price Index (CPI) Explained – Calculation and How Does it Work

How Does Cost Inflation Indexation Work?

Long-term investments are booked at acquisition cost. Despite rising inflation, they exist at the current cost price and cannot be revalued. If you sell these assets, the profit remains high because the sale price is higher than the purchase price. This also leads to higher income tax. 

The cost inflation index is applied to long-term assets that increase acquisition costs, resulting in a decrease in profits and a decrease in taxes for the benefit of taxpayers. For taxpayer profits, the profits of the Cost Inflation Index are applied to long-term capital assets, increasing acquisition costs and resulting in lower profits and taxes.

Cost Inflation Index Table: Current Index

The table below contains the revisions made so far concerning the Cost Inflation Index from 2001 to date.

What is the Purpose of CII?

The cost inflation index table calculates long-term capital gains from the transfer or sale of capital assets. The profits from the sale or transfer of fixed assets such as land, real estate, stocks, trademarks, and patents are the capital gains. In accounting, long-term assets are usually entered into the books. These investments cannot be revalued despite rising asset prices. 

Therefore, at the time of sale of these assets, the profits or profits obtained from the assets remain high due to their high selling price compared to their purchase price. As a result, assessors are required to pay higher income tax on profits from these assets.

By applying the cost inflation index to capital gains, the purchase price of an asset is adjusted to the selling price in the long run, resulting in lower profits and taxes. The Direct Tax Central Committee released new cost inflation index figures in February 2018 for applications from 2017 to 2018. This revision uses 100 as the CII and shifts from the old base year 1981 to 2001. Subsequent year indices have been adjusted accordingly. This revision of the base year was urged to solve the difficulties taxpayers face in calculating tax obligations on the profits of capital assets acquired prior to 1981.

What is the Base year in CII?

The base year is the first year of the cost inflation index, and the index value is kept at 100. Compare the index for all other years with the base year to see an increase in inflation. For all investments purchased before the base year of the Cost Inflation Index, taxpayers may accept the purchase price as higher than the actual cost or fair market value (FMV) on the first day of the base year, where FMV is based on a registered appraiser’s assessment report.

The benefits of indexing apply to the purchase price calculated in this way. Initially, 1981-82 was considered the base year. However, taxpayers had difficulty assessing homes purchased before April 1, 1981. Tax authorities also found it difficult to rely on assessment reports. Therefore, the Government has decided to change the base year to 2001 so that the assessment can be done quickly and accurately. Therefore, taxpayers will benefit from indexing capital assets acquired before April 1, 2001, assuming an actual price or FMV higher than the purchase price applicable on April 1, 2001.

Revision in Cost Inflation Index

The Central Board for Direct Taxes has released the Cost Inflation Index (CII) for the Fiscal Year 2022-23 (FY) as a 331, with notice dated 14 June 2022. The Government will use this index to measure inflation.

How CII Helps Taxpayers to Reduce Tax Liabilities?

The CBDT has set the Cost Inflation Index for the 2021-22 financial year at 317, adjusting it from 201, which was the Cost Inflation Index for the 2020-21 financial year. Since CII is used to calculate the inflation-adjusted asset acquisition cost for the computation of LTCG assets, this indexation can help reduce tax liabilities. 

The magnitude of tax applicable on long-term capital gains obtained from the transfer of assets like mutual funds and real estate can be brought down by assessees. It can be done by tweaking their total invested amount per the asset purchase CII. For example, any gain obtained by an individual from the transfer or sale of an asset will attract relevant capital gains taxes, irrespective of long or short term. If the assets are held for less than 24 months, the gains on the transfer of those assets will be treated as short-term capital gains and will not be indexed. 

However, if the assessed person holds the asset for more than 24 months at the time of sale or transfer, the CII application will be taxed at a 20% tax rate. The gain amount is automatically reduced when CII is applied to the wealth gain. Therefore, the amount taxed is also reduced, reducing the assessor’s tax liability to LTCG. 

This reduction in tax obligations is one of the main reasons for the increase in subscriptions and issuance of pension funds and fixed-term pensions (FMP). Therefore, implementing CII in LTCG allows beneficiaries to leave a surplus after paying taxes on long-term profits, which can be further used to invest in other financial instruments.

Also Read: What is Money Flow Index (MFI) and How to Use it in Trading?

Things to Know in Cost Inflation Index

Assessors should consider several important points when calculating the indexed cost of acquiring an assessor’s assets. 

1. If the asset is received at the assessor’s request, CII will be considered in the year in which it was received. In this case, the actual acquisition year of the asset is negligible. 
2. Improvement costs incurred before April 1, 2001, are not subject to indexing. 
3. The benefits of the index do not apply to bonds, except for government gold bonds or capital index bonds issued by RBI.

Final word

To calculate long-term capital gains, a cost inflation index table is used. Capital gains are the gains on the sale/transfer of capital assets. CII facilitates the calculation of capital gains on assets that were originally acquired at different times and revalued regularly. 

If you do not meet the purchase price of such assets revalued regularly, you risk underestimating long-term capital gains.

CII makes it easy to calculate the depreciation of fixed assets for tax purposes by using the revaluation price instead of the acquisition cost. CII provides a consistent way to determine capital gains or losses that are beneficial to tax authorities and taxpayers.

FAQs on Cost Inflation Index

Ans: Here are the following drawback of Cost Inflation Index: 

1. Revenues are significantly undervalued because CII is a statistical method and does not provide a legal basis for determining costs due to the inaccuracies in determining long-term capital gains from the transfer or sale of fixed assets.
2. Revenues can be significantly overvalued due to the inaccuracies in determining long-term capital gains from asset transfers or sales and the lack of occasional CII review provisions. 
3. CII does not refer to the current index, so there is a possibility that capital gains will increase due to inflationary management. Usually, any CII is used, leading to an overestimated income.