How well does the cost inflation index reflect actual inflation rates? | Mint

How well does the cost inflation index reflect actual inflation rates?

Photo: Mint
Photo: Mint

Summary

  • For the benefit of taxpayers, capital gains from certain assets are adjusted for inflation using cost inflation index
  • To calculate LTCG, the cost of acquisition and the cost of improvement of assets are linked to the CII

Here is what investors should know about the cost of acquisition of an asset, long-term capital gains or losses accrued by it, and the benefit of indexation.

The government recently notified the cost inflation index (CII) number for the current fiscal year, or FY2024, at 348, up 5.1% from the index value of 331 for FY2023. The CII, which is used to inflate the cost of acquisition of a long-term capital asset, is notified by the government every year, accounting for inflation in the preceding year.

Why is indexation important?

Consider an asset bought for 1 lakh and sold five years later. If the annual inflation rate is 5%, the asset must be sold for at least 1,27,630 so that it can compensate the effect of inflated prices. If it is sold for less, the taxpayer incurs a loss even if there is a nominal gain. In other words, without adjusting for inflation, the gain would thus be overvalued by 27,630 in the given example, which is not a ‘real’ gain to the investor.

The longer the asset is held, the greater the amount of capital gains that will be overvalued compared to the real gain. To avoid taxing such gains, capital gains from certain assets are adjusted for inflation using CII in India.

Graphic: Mint
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Graphic: Mint

We analysed if the rise in CII values is at the same pace at which the inflation in the economy is going up. To be sure, the urban CPI (consumer price index) released by government every month is considered to represent inflation. For the uninitiated, CPI calculates the retail inflation in the economy based on a basket of goods and services over time.

In the last five years, the rise in CII averaged 4.4% while urban CPI inflation during the same period averaged 5.6%. On fiscal year-wise comparison too, we observed that the rise in CII values for each year is lower than the inflation witnessed in the preceding year.

Old tax documents that are available in public domain indicate that the CII is based on “75% of average rise in the CPI for urban non-manual employees for that year." But that data is no longer being published by the government. While the methodology used for the CII is not available, Madan Sabnavis, chief economist at Bank of Baroda, says that 75% of the urban CPI number can be used to compare the uptick in CII values.

Taking into consideration all these, we observed that the rise in CII has been 10-50 basis points higher than 75% of urban CPI inflation figures reported for the previous year.

And, although it is still lower than the extent of actual inflation in the economy, it provides some relief to the taxpayers.

Note that the government removed the indexation benefit for debt mutual fund asset class recently. It is currently available only for assets such as real estate and gold.

Indexation benefit

In budget 1992, the then finance minister, Manmohan Singh, introduced a system of indexation—one that inflates the costs in proportion to the inflation in the economy—for assets held for the long term.

Since then, for long-term capital gains (LTCG) of certain assets, the cost of acquisition and cost of improvement of assets are linked to the CII which is notified by the government every year.

The indexation cost of acquisition is calculated as (Index value in the year of sale, divided by the index value in the year of purchase) and multiplied by the actual cost.

Say, Rani purchased a flat in FY2002 for 10 lakh and sold it in FY2018 for 30 lakh. The CII for 2001-02 and 2017-18 was 100 and 272, respectively. Hence, the indexed cost of acquisition is 10,00,000 x 272/100 = 2,720,000 or 27.2 lakh

The capital gains on sale of the flat was 2.8 lakh ( 30 lakh– 27.2 lakh) and not 20 lakh ( 30 lakh– 10 lakh).

Due to indexation, the purchase cost increases, resulting in lesser profits and lesser taxes to benefit taxpayers.

To take more advantage of the indexation benefit, a few investors time their investments to buy the asset at the fag end of the fiscal year and/or sell in the beginning of a fiscal year, according to Sahil Kapoor, senior executive vice president, 360 One Wealth.

Sometimes, if the return on investment is lower than the inflation reflected by CII, one can also report losses on the sale, which can be either used to offset other gains or income, added Kapoor.

Note that the index values are available only from April 2001. For a capital asset purchased before 1 April 2001, taxpayers can take either the actual cost or the fair market value (FMV), whichever is higher, as on 1 April 2001, as the purchase price and avail the benefit of indexation.

Global comparison

Before you wonder why the rise in the inflation index is lower than the actual inflation in the economy, note that many countries do not even offer the indexation benefit on capital gains.

In the US, for instance, there is a concessional tax rate for capital gains on assets held for more than one year but not the benefit of indexation. “There is no CII-adjusted cost for capital gains in the US. The actual cost is deductible in most cases. There is a cost step-up in certain cases such as inheritance, but no CII equivalent in regular cases," said Chandrika Kadur, a senior tax manager with Petrinovich Pugh & Co., a California-based firm.

In Canada, 50% of the capital gains are taxed at ordinary tax rates applicable to the taxpayer. Even after the 50% deduction, the total effective tax rate on capital gains would be higher because of the higher tax slab rates.

There are a lot of debates and proposals in the West to introduce the CII benefit for capital gains, which is considered a complex mechanism.

Sandeep Shah, managing partner, N.A. Shah Associates, said “the CII in India doesn’t match the inflation on ground but provides some relief. Since the long-term capital gains tax rate is lower than regular tax rate in India, income tax authorities may not be matching CII with actual inflation."

Investing in debt funds

The tax rules on immovable property and gold have largely been untouched since 1992. For these assets, the LTCG (holding period of more than 24 months and 36 months for immovable property and gold, respectively) and STCG is taxed at 20% with indexation benefit and at individual income tax slab rates, respectively.

The benefit of indexation for debt funds held for more than three years was eliminated recently. Gains will now be taxed at the individual’s slab rate irrespective of the holding period. “Without indexation for debt funds, the returns may not even beat inflation," added Kapoor.

To avoid higher taxation, a few mutual fund (MF) advisers and distributors suggest that investors who can take a bit more risk should invest in hybrid funds, which are treated as equity for tax purposes. Equity funds are taxed at 10% after a 1-year holding period for gains of over 1 lakh in a year. One must remember that taxation with indexation benefits is much more efficient than equity taxation, especially when the returns are lower.

An illustration in the accompanying graphic explains why indexation is a well-designed strategy, especially for debt-like products which focus on capital preservation for lower returns. Although equity taxation on hybrid funds is much better than being taxed at slab rate as per the current rules for debt funds, new strategies may emerge in the mutual fund spaces with tax-efficient products.

As per the new rules, funds with domestic equity between 35% and 65% will enjoy the benefits of the existing debt fund taxation. Most hybrid funds currently fall under ‘more than 65% equity exposure’ category which are treated as equity-like products for taxation.

Nehal Mota, co-Ffounder & CEO, Finnovate, reiterates the point that existing hybrid funds are not a substitute for debt funds and investors cannot compromise on risk profile for tax purposes. It is a matter of time before asset management companies re-engineer their debt/hybrid offerings to allow indexation benefits.

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