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Monday, December 18, 2017

Cost Inflation Index base year has shifted. You may be in for windfall tax gains

[Updated : 09-Nov-2018]
Cost Inflation Index(CII) now has a new Base Year. In a seemingly silent move that is likely to immensely impact your taxation on long term capital gains from real estate, bonds, gold and debt based mutual funds, the base year for Cost Inflation Index(CII) has been shifted from 1981 to 2001. Understand more about CII and how this change in base year impacts your future potential gains and taxes thereof.

Why Indexation?
Indexation refers to the adjustment in the purchase price of an investment for the inflation rate during the period for which it was held. This inflated cost is considered as the purchase price while computing the gains arising from the sale of the asset from the taxation perspective. When you sell property, gold, shares, mutual funds, you need to pay capital gain. If the holding period of asset i.e time between sale and purchase of the asset is more than 2 years for property and more than 3 years for unlisted shares, gold, and debt funds then one uses Cost of Inflation Index for calculating Long Term Capital Gains (LTCG) to reduce the tax.

What is CII?
CII is a measure of inflation that finds application in tax law, when computing long-term capital gains on sale of various type of assets. Section 48 of the Income-Tax Act defines the index as what is notified by the Central Government every year. Till 31 Mar 2017, capital gain was calculated with 1981 as the base year. From 1st April 2017, the base year taken for calculation would be 2001.

CII Data with base year as 1981

CII with base year as 2001

Where can I find Official CII figures?
You can find all official Cost Inflation Index (CII) figures on the Income tax website of the Government of India. Here are two specific links for the two baselines:
1/ CII with Base Year 1981
2/ CII with base year 2001

Salient Features of CII
1/ Inflation Index is reported in terms of Financial Year, not Assessment Year. In India the year for financial transactions start from 1st April and ends on 31st March following year. For example For any transaction between 1st April 2015 to 31st Mar 2016 the Indexation for year 2015-16 i.e 1081 would be used.
[Recommended Blog-post --> Financial Year Vs Assessment Year]
2/ For long-term capital gains, indexed cost of acquisition and indexed cost of improvement is deducted instead of cost of acquisition and cost of improvement.
3/ Formula for computing indexed cost =(Index for the year of sale/ Index in the year of acquisition) x cost.
4/ For example, 
If a property purchased in FY 2003-04 for Rs 40 lakh were to be sold  in FY. 2015-16 for Rs 95 lakh, indexed cost = (1081/463) x 40= Rs 93.39 lakh. And the long-term capital gains would be Rs 1.69, that is Rs 95 lakh minus Rs 93.39 lakh. This inflation adjusted costs leads to realistic gains and therefore realistic taxes to be paid on the same.

What happens if the purchase was prior to the CII Base year?
The change in the base year is across all asset classes but the impact would differ across assets that enjoy indexation benefit on long-term capital gains—real estate, unlisted shares, gold and bond funds.
Till 31 Mar 2017, capital gain was calculated with 1981 as the base year. This means that the purchase price of an asset bought before 1 April 1981 could be calculated on the basis of the "fair market value" of 1981. From 1 Apr 2017, the purchase price is calculated based on the fair market value of 2001. Accordingly, capital gains on assets acquired before 1 April 2001 will also be calculated using "fair market value" as on 2001.
If you own assets such as real estate, jewellery or bullion, which were bought before 2001, and are planning to sell them, then chances are your tax liability on gains you would make by selling them, will most likely come down significantly. We know that this will bring down the long-term capital gain (LTCG) tax liability for sellers, on assets that were acquired before 2001.

Why change in base year becomes a must?
CII gives inflation adjusted index based on overall inflation figures. However, certain sections of the economy are likely getting inflated at a much higher or lower rate than the overall inflation. As a very simple example, the overall inflation in India may be close to 5%, but the inflation in medical and health care has been more than 15% since the last decade. Such anomalies leads to high levels of inaccuracies for any calculation done based on CII data.
Rebaselining the CII base year allows us to assess the "fair market value" on a specific base year and then going forward, adjust for inflation based on CII data.

Illustrated Example of how change in base year can benefit you
To understand it better, let us illustrate this and take the case of a person who bought a property for Rs1 lakh in, say, 1975, and is planning to sell the same now.

As per the income tax rules until last year, to calculate the capital gains on the property, the property owner will first need to know the fair market value of the property as of 1981. This number will then have to be inflated according to the CII numbers, to find out the present indexed cost of acquisition. If we assume that property rates have appreciated at the rate of 15% per annum, then the fair market value of the property bought in 1975 would be about Rs 2.31 lakh in 1981. Based on this, the indexed cost of the property would be about Rs 26.02 lakh in 2016-17.
The calculation is:
Rs 2.31 lakh *(1125/100).
1125 is the CII for 2016-17 and
100 is the CII for 1981-82.
Further, if the property is currently selling at Rs1.5 crore, the capital gain would be Rs1.24 crore, and LTCG tax would be flat 20% of the gain i.e. Rs 25.54 lakh.

However, with the change in the base year, from this financial year, one would have to calculate the fair market value of the property as it was in 2001. The shift in the CII base year from 1981 to 2001 will drastically change the final capital gains amount from the property. This is so because the property prices appreciated at a much higher rate between 1981 and 2001, compared to the increase in CII.

If we go as per CII figures, the property valued at Rs 2.31 lakh in 1981 would be valued at Rs 9.84 lakh in 2001 [Rs2.31*(426 (CII 2001-02)/100 (CII 1981-82)],
On the other hand, if we assume that the property price appreciated at a high rate of, say, 15% per annum during the same period, then the fair market value of the property would have been about Rs 37.86 lakh in 2001. Further, based on the fair market value of the property in 2001, the inflated cost of acquisition at present would be about Rs 99.97 lakh (Rs37.86*(1125/426)). In such a case, the LTCG would be around Rs 50.03 lakh, and the tax liability would be Rs 10.3 lakh. This means that the shift in the base year would result in tax savings of about Rs 15.24 lakh (Rs 25.54 less Rs 10.30) if you decide to pay tax on the LTCG.

Want to save taxes on Long Term Capital Gains? you can do away even with zero tax. Read here.
The book From the Rat Race to Financial Freedom has many such concepts which can help you manage your money more wisely. It can help you approach financial freedom faster.

Article History
09-Nov-2018 : Official CII data links added
18-Dec-2017 : Original


Manoj Arora

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