What is Indexation?

Indexation is the adjustment of income payment in order to maintain purchasing power. Purchasing power is the ability of one unit of currency to buy goods or services. This is the deciding factor of the quality of life the citizens are living as it directly affects the inflation and capital gain. To further understand the indexation we need to learn about two major terms and that is-

  • Inflation
  • Capital Gain

Inflation

What is Indexation

Inflation is the increase in the price of product or service. The increase in inflation results in buying few things for the same amount and the inverse is also applicable meaning when the inflation goes down the purchasing power increases and we are able to buy more goods and services for the same amount.

Capital Gain

Capital Gain is the gradual increase in the value of the asset over time. It can also be defined as the difference in the purchase price and current market price of an investment.

How Indexation Works?

Indexation can be used to inflate the purchasing power using the Cost Inflation Index. Indexation is a benefit provided for the investors who invest in Long Term Capital Gains (LTCG) and save taxes on it. LTCG is taxed at 20 percent with the indexation benefit and indexation allows you to increase the Purchase Price using Cost Inflation Index.

Cost Inflation Index

Cost Inflation Index or CII is a factor used to calculate the Long Term Capital Gains. It is fixed by the central government in its official gazette to measure inflation. Section 48 of the Indian Income Tax Act, 1961, defines the index as notified by the government every year. The following are the indexation cost for the respective financial years-

Historical Cost Inflation Index

S.No. Financial Year Cost Inflation Index
1 2001-02 100
2 2002-03 105
3 2003-04 109
4 2004-05 113
5 2005-06 117
6 2006-07 122
7 2007-08 129
8 2008-09 137
9 2009-10 148
10 2010-11 167
11 2011-12 184
12 2012-13 200
13 2013-14 220
14 2014-15 240
15 2015-16 254
16 2016-17 264
17 2017-18 272
18 2018-19 280

Formula for Cost Inflation Index

Indexed cost = (CII for the year of sale/ CII for the year of purchase) X (Cost of purchase) 

For Example- let’s assume that Mr.Sharma purchased a home for Rs.30Lakhs on the 2 Feb 2006. Now Mr.Sharma is selling his home for Rs.55 Lakhs dated on 2 March 2019. So the indexation cost is calculated as follows-

By applying the Index Cost Formula we get-

(280/177) X 30, 00, 000= 47, 45,762/-

The calculation of the indexation helped the purchase of the home to increase which resulted in an increase in the value of the purchasing of the home.

So the tax payment for the capital gain on the sales of purchase can further be calculated as

55,00,000 Sale value- 47, 45,762/- Index Cost = 7,54,238

Therefore, the capital gain on the sale of the home is Rs.7, 54, 238/-

The calculation of tax on the long term capital gain is calculated with 20% of the tax. Therefore 20% of the 7,54,238 is  Rs.1,50,848.

Indexation helps the investor here Mr.Sharma to increase the Purchase Price which further reduced the capital gain and the tax amount is reduced which made Mr.Sharma to pay less tax than what a normal sales require to pay without indexation.