How correctly does the worth inflation index replicate exact inflation prices?

The authorities these days notified the worth inflation index (CII) amount for the current fiscal 12 months, or FY2024, at 348, up 5.1% from the index value of 331 for FY2023. The CII, which is used to inflate the worth of acquisition of a long-term capital asset, is notified by the federal authorities yearly, accounting for inflation throughout the earlier 12 months.

Why is indexation important?

Consider an asset bought for ₹1 lakh and provided 5 years later. If the annual inflation price is 5%, the asset should be provided for at least ₹1,27,630 so that it would compensate the impression of inflated prices. If it is provided for a lot much less, the taxpayer incurs a loss even when there is a nominal obtain. In completely different phrases, with out adjusting for inflation, the obtain would thus be overvalued by ₹27,630 throughout the given occasion, which is not a ‘real’ obtain to the investor.

The longer the asset is held, the bigger the amount of capital options that may most likely be overvalued compared with the true obtain. To steer clear of taxing such options, capital options from certain belongings are adjusted for inflation using CII in India.

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Graphic: Mint

We analysed if the rise in CII values is on the equivalent tempo at which the inflation throughout the financial system goes up. To make sure, the town CPI (shopper worth index) launched by authorities every month is taken under consideration to represent inflation. For the uninitiated, CPI calculates the retail inflation throughout the financial system based on a basket of merchandise and firms over time.

In the ultimate 5 years, the rise in CII averaged 4.4% whereas metropolis CPI inflation all through the equivalent interval averaged 5.6%. On fiscal year-wise comparability too, we observed that the rise in CII values for yearly is lower than the inflation witnessed throughout the earlier 12 months.

Old tax paperwork that are accessible in public space level out that the CII is based on “75% of widespread rise throughout the CPI for metropolis non-manual workers for that 12 months.” 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, partner—third party products at IIFL Wealth Management.

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 supervisor with Petrinovich Pugh & Co., a California-based company.

In Canada, 50% of the capital options are taxed at extraordinary tax prices related to the taxpayer. Even after the 50% deduction, all the environment friendly tax price on capital options might be better because of the higher tax slab prices.

There are a great deal of debates and proposals throughout the West to introduce the CII revenue for capital options, which is taken under consideration a elaborate mechanism.

Sandeep Shah, managing confederate, N.A. Shah Associates, said “the CII in India doesn’t match the inflation on ground nevertheless provides some assist. Since the long-term capital options tax price is lower than widespread tax price in India, earnings tax authorities won’t be matching CII with exact 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 steer clear of better taxation, a few mutual fund (MF) advisers and distributors advocate that merchants who can take a bit additional hazard must spend cash on hybrid funds, which might be dealt with as equity for tax capabilities. Equity funds are taxed at 10% after a 1-year holding interval for options of over ₹1 lakh in a 12 months. One ought to don’t forget that taxation with indexation benefits is much extra atmosphere pleasant than equity taxation, significantly when the returns are lower.

An illustration throughout the accompanying graphic explains why indexation is a well-designed method, significantly for debt-like merchandise which take care of capital preservation for lower returns. Although equity taxation on hybrid funds is lots higher than being taxed at slab price as per the current pointers for debt funds, new strategies might emerge throughout the mutual fund areas with tax-efficient merchandise.

As per the model new pointers, funds with dwelling equity between 35% and 65% will benefit from some great benefits of the current debt fund taxation. Most hybrid funds in the meanwhile fall beneath ‘more than 65% equity exposure’ class which might be dealt with as equity-like merchandise for taxation.

Nahal Mota reiterates the aim that present hybrid funds normally aren’t another choice to debt funds and merchants cannot compromise on hazard profile for tax capabilities. It is a matter of time sooner than asset administration companies re-engineer their debt/hybrid decisions to allow indexation benefits.

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