Cost Inflation Index for FY 2015-16
Announcements for the cost inflation index (CII) for fiscal year 2015-16 came in late. While people have been waiting since April, government and Central Board of Direct Taxes took their own sweet time to announce the new CII. As of now, the CII for the fiscal year 2015-16 stands at 1081.
Now, if you are wondering what cost inflation index stands for and why people have been waiting impatiently for this announcement, let us take a quick tour of the financial world and understand what CII means, how it is calculated and why it is important for Indian citizens.
In order to find answers to these questions, we need to understand a couple of other concepts which are: Capital Gains and Indexation.
Let us suppose you have an asset in form of a house. You purchased it. Now you decide to sell it. It is logical that you will sell your house at a higher price compared to the price you paid for its purchase. This will help you to earn some profits. This profit is called capital gains.
When presented in form of a simple equation:
Capital Gains = Selling price of the asset – purchase price of the asset
If an asset is sold within 12 months from the date of purchase and profits are earned, the earned profit is called short term capital gain. If the asset is sold after 36 months from the date of purchase, the earned profit is called long term capital gain.
Now, a house is not the only asset you can own. There are many others like jewelry, bonds, shares, etc. Only those assets can lead to capital gains which appreciate in value over time. So, if you think you can sell your computer after 2 years at a price higher than the price at which you purchased it, you are wrong! An asset like a computer only loses its value over time because the internal parts of the computer become obsolete. Thus, capital gains is possible only for assets that increase in value over time.
Now, the equation above is in its simplest form. This is not how capital gains are calculated. The actual equation is more complex and is represented as:
Capital Gains = [Full Sale Value] – [Indexed Acquisition Cost] – [Indexed Improvement Cost] – [Exemptions]
For the purpose of simplicity, let us get rid of the parts [Indexed Improvement Cost] and [Exemptions]. So, if we remove those two parts, the formula becomes:
Capital Gains = [Full Asset Sale Value] – [Indexed Acquisition Cost]
In this shortened formula we see the word ‘Indexed’. What is it? Why is it added? Before we answer those questions, let us take a look at the formula for [Indexed Acquisition Cost].
[Indexed Acquisition Cost] = [Acquisition cost] x [CII or Cost Inflation Index]
So, the formula for capital gains can now be represented as:
Capital Gains = [Full Asset Sale Value] – [[Acquisition cost] x [CII or Cost Inflation Index]]
Acquisition cost is a fairly simple concept. It represents the price at which you purchased your asset. Full sale value represents the price at which you sold your asset. So, we are left with CII or cost inflation index. Let us try to understand it.
Cost Inflation Index
Let us begin with a simple example of a packet of tea. What is the price you used to pay for a packet of tea 5 years back and what is the price you pay for the same packet today? Definitely you pay a much higher price! This is called inflation. This is true for everything in our life. For example, the soap we use, the food we eat, the water we drink, the electricity we use… prices of everything we depend on in our day-to-day life has increased from what it used to be a few years back and the prices will continue to increase in the years to come. This year-over-year increase in price is called inflation. Inflation increases our cost of living.
It is a proven point that asset value, over time, decreases as inflation increases. It is very true that an asset like a housing property can be purchased at a lower price and several years later, sold at a higher price. This happens not just because of inflation but also because of increased demand. Selling at a higher price means capital gains and this where tax-hungry government steps in to levy a tax on the gained capital, which is technically known as Capital Gain Tax. Now the problem here is that despite capital gains, the person making the money has been under the influence of inflation-induced higher cost of living and at the same time, suffered a loss of asset value, also because of inflation. Hence, the eventual capital gain has already been partially offset over years. Government is generous enough to take account of this loss and hence, never imposes tax on the entire gain capital amount, thereby safeguarding the person from further loss.
To account for inflation and the associated increase in cost of living and decrease in asset value, government allows the asset owner to increase the purchase price of the asset and decrease the overall profit from asset sell. This in turn translates into lower Capital Gain Tax.This allowed upward thrust on purchase price is technically known as indexation. Once purchase price gets upward adjustment for years of inflation, the new calculated value that is arrived is technically known as indexed acquisition cost.
However, working with the definition is not enough. We need to actually calculate indexed acquisition cost. In order to achieve that, we need cost inflation index which is popular by its abbreviated form, CII. CII has its own formula which is:
CII = [CII for the year of selling the asset] / [CII for the year of purchasing the asset]
So with that formula for CII, the formula for Capital Gains becomes:
Capital Gains = [Full Asset Sale Value] – [[Acquisition cost] x [CII for the year of selling the asset] / [CII for the year of purchasing the asset]]
A Quick Example:
Let us assume that you purchased a house in year 2005 at a price of ₹ 20,00,000 and sold the property in 2011 at a price of ₹ 52,00,000.
Assuming that the CII for 2005 was 497 and the CII for 2011 was 711, your capital gains was calculated as:
Capital Gains = 5200000 – [2000000 x [711/497]] = 2861167
So, after adjusting prices for inflation, you paid Capital Gain Tax on ₹ 28,61,167.
What if you were not allowed to make upward price adjustments to negate the impact of inflation? If that happened, government would be taxing you on ₹ 32,00,000, which is the difference between the selling price and the unadjusted purchase price. Simply put, you would end up paying more tax!
So, why is cost inflation index necessary?
It is necessary because it allows people to reduce the capital gain taxes they need to pay to the government in case they sell any asset. This is precisely why people have been impatiently waiting for the announcement of CII for fiscal year 2015-16.
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