What is Cost Inflation Index :

The rising cost of all articles, popularly known as inflation, has its impact on every investor.  An index which accounts for annual inflation can be called cost inflation index.   In layman's language we can say that it is tool used to measure the rate of inflation in an economy.  Such an index is used for various purposes, including in income tax.  In India,  Section 48 of the Income Tax Act defines the index as what is notified by the Central Government every year, having regard to 75% of average rise in the Consumer Price Index (CPI) for urban non manual employees for the immediate preceding year.    The table given at the end of this article gives these figures since 1981.

How cost inflation index is useful in reducing income tax in India?

We know that indexation of  the cost of asset  allows the investors to save a substantial amount of income tax on his long term capital gains arising out of selling of movable / immovable properties, if he takes the advantage of the cost of inflation index allowed under IT Act.   However, this indexation is available only on fulfilling certain criteria.  

Let us go through some of the basic rules for this indexation :

(a) Cost of acquisition of the asset whether movable or immovable is first to be multiplied by the cost of inflation of the year in which the asset is being transferred.

(b) The resultant figure obtained as above under (a) will then be divided by the cost of inflation index for the year in which the asset was acquired. 

(c) The cost of inflation for various years since 1981 is given below.   In case the asset was purchased before 1st April, 1981, the cost inflation index for the purpose of acquisition is to be taken as the one on 1st April, 1981

(d) The costs incurred on the improvement of the said asset are to be similarly adjusted with the help of the cost of inflation index i.e. by multiplying the cost inflation index for the year in which the improvements to the said asset were done.

PS : It should be noted that the benefit of cost inflation index is not available for short term capital gain or losses.   This means that the sale of the assets if acquired within a period of less than three years (36 months) from the date of purchases, will be treated as short term capital gains or losses.  In such cases, the benefit of indexation can not be availed.   Moreover, this benefit is also not available to Non Resident Indians.

In nut shell, we can say that investors can pay much less tax for the assets held by them for over 3 years by taking advantage of the indexation.

Let us understand the above by an example :

Rahul purchased a property for Rs 5,00,000 in the year and sold the same in the financial year 2013-14 for Rs 48,00,000. The long term capital gain would be calculated as under :

The indexed cost of the property will be Rs500000 x 939/100 = 46,95,000.   However, his selling price was Rs48,00,000/-.  This means the total long term income from the sale of the property will be only Rs48,00,000 - Rs46,95,000 or Rs1,05,000/.   In case the sale of property has been below Rs 46,95,00, it would have been long term loss for Rahul, which could have been set off against other long term gains.