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Inflation typically is the rise in the general level of price of goods & services over a period of time. In the earlier times, such inflation was benchmarked by checking the increase in the price of bread, which was the staple food of common men in the western countries.

 

Accordingly, consumer price index (CPI) is a measure of estimating the average price of consumer goods and services purchased by households and can be used to adjust the effect of inflation on the real purchasing power of money.

The government with regard to this CPI, notifies the index for a financial year that can be used for upward adjustment of the cost for any long term capital asset.

 

The Cost Inflation Index (CII) for FY 2013-14 has been notified by the Central Board for Direct Taxes (CBDT) as 939. This CII was notified on June 6, 2013 vide Notification No. 40/2013/F.No.142/7/2013-TPL

The idea of indexation is to allow you to consider the current cost of the asset so that it can be realistically compared with the current sale value to define actual capital gains. Such indexation of cost helps you to effectively reduce the tax outflow on account of any capital gain resulting out of sale of any long term capital asset. (Click here to know how to pay Zero tax on capital gains).

 

An example to illustrate the reduction in tax due to indexation has been mentioned below:

Sr. No.	Particulars	Example with Indexation	Example without Indexation
1.	Purchase cost	20,00,000	20,00,000
2.	Year of purchase	2007-08	2007-08
3.	Cost Inflation Index (notified by Government)	551	-
4.	Sale Value	30,00,000	30,00,000
5.	Sale Year	2012-13	2012-13
6.	Cost Inflation Index	939
7.	Indexed cost of purchase (1x6)/3 = 7	34,08,348	-
8.	Capital Gain / (Loss) (4 - 7 = 8)	(4,08,348)	10,00,000
9.	Tax on Capital Gains @ 20%	Nil	1,00,000

 

Thus it can be seen that by increasing the cost of acquisition by using the cost inflation index, the entire position of capital gain is reversed to loss thus not requiring the person to pay any tax on such sale.