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

The government recently notified the Cost Inflation Index (CII) number for the current financial year or FY2024 at 348, which is 5.1% higher than the index value of 331 for FY2023. CII, which is used to calculate the cost of acquisition of a long-term capital asset, is notified by the government every year, accounting for inflation in the previous year.

Why is indexation important?

Consider the property purchased for 1 lakh and was sold after five years. If the annual inflation rate is 5%, the asset should be sold at least 1,27,630 so that it can offset the effect of increased prices. If it is sold for less, the taxpayer has to bear the loss even if there is a marginal profit. In other words, without adjusting for inflation, profit would thus exceed 27,630 in the given example, which is not a ‘real’ profit for the investor.

The longer the asset is held, the greater the amount of capital gain which is higher than the realized gain. To avoid taxing such gains, capital gains from certain properties are adjusted for inflation using CII in India.

We analyzed whether the increase in CII values ​​is in line with the rate at which inflation is increasing in the economy. To be sure, the urban CPI (consumer price index) released by the government every month is believed to represent inflation. The CPI calculates retail inflation in an economy based on a basket of goods and services over time.

Over the past five years, growth in CII averaged 4.4%, while urban CPI inflation averaged 5.6% during the same period. Even on the financial year-wise comparison, we observed that the increase in CII values ​​each year is lower than the inflation seen in the previous year.

Older tax documents available in the public domain indicate that the CII is based on “75% of the average increase in CPI for urban non-manual workers for that year”. But that data is no longer being published by the government. While the methodology used for CII is not available, Bank of Baroda chief economist Madan Sabnavis says that 75% of the urban CPI numbers can be used to compare growth in CII values.

Taking all this into account, we observe that the increase in CII is 10-50 basis points higher than the 75% of urban CPI inflation reported for the previous year.

And, although it is still below the actual inflation range in the economy, it provides some relief to the taxpayers.

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

indexation benefit

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

Since then, for long-term capital gains (LTCG) of certain properties, the cost of acquisition of the property and the cost of improvements to the property have been linked to the CII which is notified by the government every year.

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

Let me tell you, Rani had bought a flat in FY2002. 10 lakhs and sold it in FY2018 30 million. The CII for 2001-02 and 2017-18 was 100 and 272 respectively. Therefore, the indexed cost of acquisition will be 10,00,000 x 272/100 = 2,720,000 or 27.2 lakh

Capital gain on sale of flat was 2.8 Lakh ( 30 million- 27.2 Lakh) and no more 2 million ( 30 million- 10 lakh).

Due to indexation, the purchase cost goes up, resulting in less profit and less tax to pass on to the taxpayers.

To make the most of indexation benefits, some investors time their investments to buy assets at the end of the financial year and/or sell at the beginning of the financial year, according to Sahil Kapoor, Partner-Third Party Products, IIFL Wealth Management.

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

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

global comparison

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

For example, in the US, there is a concessional tax rate for capital gains on assets held for more than a year, but no benefit of indexation. “There is no CII-adjusted cost for capital gains in the US. The actual cost is deductible in most cases. The cost goes up in some cases, such as inheritances, but there is no CII equivalent in regular cases,” says Petrinovich, a California-based firm. said Chandrika Kadur, a senior tax manager at Pugh & Co.

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

There is a lot of debate and proposal in the West to introduce CII for capital gains, which is considered a complicated mechanism.

Sandeep Shah, managing partner, NA Shah Associates, said, “CII in India does not match inflation on the ground, but does provide some relief. Since the long-term capital gains tax rate is lower than the regular tax rate in India, the income tax authorities cannot match the CII with actual inflation.”

investing in debt funds

Tax rules on real estate and gold have remained largely untouched since 1992. For these assets, LTCG (holding period of more than 24 months and 36 months for real estate and gold respectively) and STCG are taxed at 20% with indexation benefit. and at individual income tax slab rates, respectively.

The benefit of indexation was recently waived off for debt funds held for more than three years. Now gains will be taxed at the slab rate of the individual, irrespective of the holding period. “Without indexation for debt funds, the returns may not even beat inflation,” said Kapoor.

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

An example in the attached graphic illustrates why indexation is a well-designed strategy, especially for debt-like products that focus on capital preservation for low returns. While equity taxation on hybrid funds is much better than taxing them at the slab rate as per the current rules for debt funds, new strategies may emerge in the mutual fund space with tax-efficient products.

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

Nahal Mota reiterates that the existing hybrid funds are not a substitute for debt funds and investors cannot compromise on the risk profile for tax purposes. It is high time that Asset Management Companies re-engineer their debt/hybrid offerings to give indexation benefits.