On selling of a capital asset one needs to pay taxes on it under the head ‘capital gains’. However, indexation benefit is entitled that allows to escalate the cost of the asset by considering a notified inflation factor known as ‘cost inflation index’. The enhanced cost that is arrived at after applying this index is called the ‘indexed cost’. The indexed cost is deducted from the sale proceeds to arrive at the taxable profit.

The cost of indexation includes the cost of acquisition & the improvement cost made on the asset.  

The benefit of indexation is given to counteract the erosion in the value of an asset on account of inflation. The cost is, therefore, artificially inflated by applying the cost inflation index to bring the value of the asset at par with the prevailing market rate to a certain extent. This cost inflation index factor is notified by the government every year with the base year starting from 1 April 1981, that is, financial year 1981-82, with an index of 100. Last year, the index was ‘852’, and this year it is ‘939’. This would mean that there has been a 10.2 per cent rise in the cost inflation index for 2013-14.

A cost inflation index helps reduce the inflationary gains, thereby reducing the long-term capital gains tax payout for a taxpayer.

For assets acquired before 1 April 1981, one has the option to take the cost as the fair market value as on 1 April 1981. The fair market value would then be driven up with the help of the cost inflation index to arrive at the indexed cost. Where the asset is acquired before 1 April 1981 and one does not opt to take the fair market value on that date as the cost, but instead choose to take the actual amount spent to buy the asset, the cost inflation index for the year of acquisition would still be taken at the base index of 100.

The benefit of the indexed cost of acquisition is allowed only in the case of long-term capital assets, i.e., those that are held for more than 36 months. In the case of shares, listed securities and units of the Unit Trust of India or a mutual fund, the minimum period of holding is 12 months.

The benefit of indexation can be way to minimize taxes that can only be availed for the period for which one holds the asset. The term of 36 months or 12 months is counted from the date of purchase. However, where the asset is acquired in any other mode (such as by way of a will, gift, partition of a Hindu Undivided Family, succession, inheritance or devolution) it can be said that the period of holding is the aggregate period for which both present and the previous owner have held the asset.

This relief cannot be availed in case of the following items:

• In the case of debentures and bonds. Hence, if one sells a debenture or bond, one will have to pay tax on the difference between the sale proceeds and the cost price.
• Assets that are subject to depreciation are also not eligible for the benefits of indexation.

Thinking out the taxation part?

Generally, the sale proceeds that are in excess of the indexed cost are taxed at 20 per cent. Listed securities and units are, however, entitled to a special treatment. One has the option to pay tax at 20 per cent after indexation or 10 per cent without taking into account the benefits of indexation. In most cases, however, the cost inflation index heavily reduces the tax burden on the sale of an asset, since it artificially increases the cost to bring it at par with the present market value.

Click here to know more about Indexation on Capital Assets

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