What is cost inflation index?
The Central Board of Direct Taxes maintains the CII, and the figure is updated annually. The base year is taken as 1980-81. Each year after this, the value is adjusted in proportion with the inflation recorded for that financial year (FY). Until last year, ie. 2015-16, CII was 1,081 and for FY17 it has been notified as 1,125, reflecting an inflationary increase of 4.07% over the previous year. Similarly, a specific CII has been notified for each FY from 1980-81 onwards.

Impact on capital gains tax
The importance of this inflation index is seen in calculating capital gains on assets and the tax applicable thereon. When you buy and sell financial or physical assets, any gains earned are subject to capital gains tax. If you have held an asset for more than 36 months before selling, you are liable to pay long-term capital gains tax on the profit made.

Considering the impact of inflation on the long-term value of assets, the income tax authority allows you to adjust or index your cost of purchase according to CII.

For physical assets like property, provision of calculating capital gains tax without indexation is not available. Till July 2014, for financial assets like mutual funds (non-equity mutual funds), there was an option of paying tax at a rate of 10% without indexation. But this is no longer available for units sold after 10 July 2014. A long-term capital gains tax of 20% is applied to assets sold after 36 months after indexing or adjusting the purchase price according to the CII. In years of high inflation, it is possible that the indexed cost is higher than the sale value. Let's say you index the cost based on the CII value in 2010 and 2015. The value of purchase would be 1024/632 * 10,00,000 or R16,20,253. This works out to be more than what you got while selling the flat. On indexation, there is no capital gains and no tax to be paid.

In years of high inflation, it is possible for such a scenario to take place. While, inflation has come down in the last year, between FY10 and FY15 the inflation index remained high. In years of relatively lower inflation-as seen in the last financial year-it is possible that the indexed capital gains for a similar purchase and sale value will be more than that for years when inflation is high. Hence, tax based on indexation could be higher. This happens because the value of the rupee itself declines faster in years of high inflation and vice versa.