What is Cost Inflation Index: All you need to know!

The global economy is dynamic and changes continuously due to a number of factors such as economic policies, economic growth, political events, changes in the market, news, etc. One such phenomenon that is widely prevalent is the decrease in the purchasing power of money. The reduction in the actual value of money happens due to a rise in the prices of goods and services. The increase in prices leads to an increase in the cost of living for an individual, which is known as inflation. Cost Inflation Index or CII is a tool used to calculate the estimated year-on-year rise in the prices of goods and assets due to inflation.

What is Cost Inflation Index (CII)?

CII helps in the calculation of the yearly rise in prices of goods and assets because of inflation. CII index is calculated every year to help individuals to show the adjusted value of capital gains earned from selling of capital assets and thereby reduce tax liabilities. Capital gains refer to the profit earned from selling any capital asset like land, house property, shares, patents, etc. 

Purpose of CII

In bookkeeping, long term capital assets are usually recorded at their cost prices, which poses a taxation problem because despite inflation, these prices cannot be evaluated as per the prevailing costs. Thus, the profits earned from selling a capital asset remain high because of a substantial difference between the selling and cost price of the asset. An individual ends up paying higher income tax because of higher capital gains. 

Cost Inflation Index for capital gains helps to adjust the cost price of the asset according to its sale price. The adjusted cost price leads to lower profits and subsequently a lower capital gain tax.

Revision in CII

The new Cost Inflation Index chart was released in February 2008 by the Central Board of Direct Taxes. The base year was changed to 2001 from 1981 and the indices or indexation prices for all following years were also changed accordingly. The revision solved the difficulties taxpayers were facing in calculating the capital gain taxes on assets in 1981 or before. Let us now compare the old and new capital gain indexation charts for the last ten financial years.

New CII Chart (FY 2009-10 to 2024-25)

The new capital gains index is important for taxpayers to calculate their tax liabilities on long-term capital gains correctly and file their ITR accordingly.

Things to Know in CII

Base Year

The base year works as a benchmark on which basis the CII values of all the subsequent years are calculated. It is the first year in the index with a value of 100. The CII values of the years following the base year are calculated in accordance with the increase in inflation over that of the base year.

On the other hand, for the assets purchased before the base year, taxpayers can consider the price of the asset either as its Fair Market Value or its actual cost on the Day 1 of the base year. The FMV of the asset is calculated as per its valuation report prepared by a registered valuer. 

The indexation is then applied on the purchase price of the asset and the value is adjusted accordingly.

Indexation on Long Term Capital Gains

Cost of inflation index or the indexed cost of asset acquisition/improvement is calculated by applying indexation on the price at which the asset is purchased to adjust the price with inflation. 

Formula for Indexed Cost of Asset Acquisition

(CII for the year of sale or transfer of the asset x Cost of acquisition of the asset) / CII for the first year of the holding period of the asset or year 2001-02, whichever comes later.

Formula for Indexed Cost of Asset Improvement

(CII for the year of sale or transfer of the asset x Cost of improvement of the asset) / CII for the first year of the holding period of the asset or year 2001-02, whichever comes later.

Let us understand this with an example:

Mr. X purchased a capital asset in FY 1998-99 for Rs. 10,00,000. The Fair Market Value or FMV of the capital asset on April 1, 2001, was Rs. 20,20,000. Mr. X then sold this asset in the FY 2024-25.

As can be seen from the example, Mr. X purchased the asset before the base year. Therefore, the cost of asset acquisition will be the higher one between FMV and the actual cost of the asset, as on April 1, 2001. Therefore, the cost of asset acquisition = Rs. 20,20,000.

CII for FY 2001-02 (base year) and 2024-25 (year in which the asset is sold) is 100 and 363, respectively. Therefore, the indexed cost of asset acquisition = (20,20,000 x 363)/100 = Rs. 73,32,600.

How Taxpayers Can Reduce Tax Liabilities With the Help of CII?

Following major tax reforms in 2024, the ability for taxpayers to use the Cost Inflation Index (CII) to reduce tax liabilities has become highly specific. While indexation was previously a widespread method to lower taxes on long-term capital gains (LTCG), its application is now significantly limited. For sales on or after July 23, 2024, the primary asset where CII remains a crucial tax-saving tool is immovable property (land or a building) under specific conditions. The taxpayer can only benefit from this if the property, held for more than 24 months, was acquired before July 23, 2024. For most other assets, such as gold and debt mutual funds, the indexation benefit has been withdrawn and replaced with a flat tax rate, making gains from sales within 24 months short-term capital gains (STCG) and those held longer long-term capital gains (LTCG).

For qualifying real estate transactions, resident individuals and Hindu Undivided Families (HUFs) have an important choice that can lower their tax outgo. They can opt to calculate their LTCG tax using one of two methods: either pay a 20% tax with the benefit of indexation or pay a flat 12.5% tax without indexation. Indexation helps reduce the tax liability by inflating the purchase cost of the property, which in turn reduces the taxable capital gain. A taxpayer would choose the 20% rate with CII if the resulting tax is lower than the 12.5% tax on the non-indexed gain, a scenario common with properties held for very long periods. The saved amount can be used for further investments, which is an additional benefit of correctly applying CII, where it is still permitted.