The cost inflation index otherwise known as CII is a tool that helps in the calculation of the inflation-led increases in the price of an asset on an annual basis. This index is fixed in India by the central government and is the official criteria for measuring inflation. The index is defined under section 48 of the income tax act 1961.
Why is CII important?
Due to inflation, the prices of goods increase with time. This depreciates the purchasing power of the money. The Cost inflation index could help the government and RBI in estimating the increase in prices of goods and assets on yearly basis and to contain the effects using different fiscal and monetary policies. It also helps the people and businesses in estimating the price of the assets they own. Therefore directly or indirectly it affects everyone from a Kirana shop owner to a real estate investor
How is the consumer inflation index calculated?
The CII takes into consideration the consumer price index for a specific financial year for the urban employees
The basic formula for calculating the Consumer inflation index is:
CII = 75% of rising in CPI(urban) for the immediately preceding year
Note: CPI or consumer price index helps in comparing the current prices of predetermined basked of goods and services with the price of the same goods and services basket in the previous year. This helps in objectively measuring the increase in prices.
What is the purpose of CII?
The cost inflation index helps in calculating the capital gains generated from the transfer or sale of capital assets. It is typically done on a long term basis.
Wondering what is the difference between long term and short term capital gain?
Capital gains typically refer to the profit that is acquired post the sale or transfer of any capital asset such as shares, stocks, property, trademarks etc. The tax charged on such gains is referred to as capital gains tax.
In bookkeeping the capital assets are generally recorded at their cost price. Hence even if the prices of these assets rise they cannot be revalued.
What is the use of base year in computing cost inflation index?
The base year is regarded as the reference year in comparison to which inflation is measured. Its index value is 100. The indexation of all other years is measured in comparison to the base year to estimate how much the inflation has escalated in comparison to the base year.
In case the purchase is made before the base year, the fair market value of FMV can be used.
For long term capital assets, indexation is applied to the cost of asset acquisition. This helps in adjusting the price of assets with respect to inflation.
Some important pointers with respect to cost inflation index estimation in India:
- If the asset is transferred as part of the will, the CII is taken for the year in which the asset was received by the beneficiary
- If there has been any improvement cost before 1st April 2001 it will not be viable for indexation
- Indexation benefits can be availed for RBI issued sovereign gold bonds or capital indexation bonds but not for debentures or bonds.
Note: The base payment of Capital indexed bonds rises or falls with the CPI.